Chapter 38: Balance of Payments, Exchange Rates, & Trade Deficits
In chapter 37 we examined comparative advantage as the underlying economic
basis of world trade and discussed the effects of barriers to free trade. Now we
introduce the highly important monetary and financial aspects of international
trade.
International Financial Transactions
This chapter focuses on international financial transactions, the vast majority of
which fall into two broad categories: international trade and international asset
transactions.
 International trade involves either purchasing or selling currently produced
goods or services across an international border. Examples include an
Egyptian firm exporting cotton to the U.S. and an American company hiring
an Indian call center to answer its phones.
 International asset transactions involve the transfer of the property rights
to either real or financial assets between the citizens of one country and
the citizens of another country. It includes activities like buying foreign
stocks or selling your house to a foreigner.
In either case, money flows from the buyers of the goods, services, or assets to
the sellers of the goods, services, or assets. When the people engaged in any
transactions are both from places that use the same currency, what type of
money to use is not an issue. However, when the people involved in an exchange
are from places that use different currencies, intermediate asset transactions
have to take place: the buyers must convert their own currencies into currencies
that the sellers use and accept.
The Balance of Payments
A nation’s balance of payments is the sum of all the financial transactions that
take place between its residents and the residents of foreign nations. Most of
these transactions fall into the two main categories that we have just discussed.
But the balance of payments also includes international transactions that fall
outside of these main categories, things such as tourist expenditures, interest and
dividends received or paid abroad, debt forgiveness, and remittances made by
immigrants to their relatives back home.
Table 38.1 is a simplified balance of payments statement for the United States in
2009. The balance of payments statement is organized into two broad categories;
the current account and the capital and financial account.
1. Current Account- summarizes U.S. trade in currently produced goods and
services. Items 1 and 2 show U.S. exports and imports of goods. Exports
have a (+) sign because they are a credit; they generate flows of money to
the United States. Imports have a (-) sign because they are a debit; they
cause flows of money out of the U.S.
 Balance on Goods- A country’s balance of trade on goods is the difference
between its exports and its imports of goods. If exports exceed imports, the
result is a trade surplus. If imports exceed exports, there is a trade deficit
on the balance of goods. We note in item 3 that in 2009 the U.S. incurred a
trade deficit on goods of $517 billion.
 Balance on Services- the U.S. exports not only goods such as airplanes and
computer software, but also services, such as insurance, consulting, travel,
and investment advice to residents of foreign countries. Summed together,
items 4 and 5 indicate that the balance on services, item 6, was $138
billion. The balance on goods and services shown in item 7 is the difference
between U.S. exports of goods and services, and imports of goods and
services. In 2009, U.S. imports of goods and services exceeded U.S. exports
of goods and services by $379 billion. So a trade deficit of that amount
occurred. In contrast, a trade surplus occurs when exports of goods and
services exceed imports of goods and services. Global Perspective 38.1
shows U.S. trade deficits and surpluses with selected nations.
 Balance on Current Account- items 8 and 9 are listed as part of the current
account because they are international financial flows. For instance, item 8,
net investment income represents the difference between the interest and
dividend payments foreigners paid U.S. citizens and companies for services
provided by U.S. capital invested abroad, and the interest and dividends the
U.S. citizens and companies paid for the services provided by foreign capital
invested here. Observe that in 2009 U.S. net investment income was a
positive $89 billion. Item 9 shows net transfers, both public and private,
between the U.S. and the rest of the world. Included here is foreign aid,
pensions paid to U.S. citizens living abroad, and remittances by immigrants
to relatives abroad. These $130 billion of transfers are net U.S. outpayments, and therefore listed as a negative number. By adding all
transactions in the current account, we obtain the balance on current
account, shown in item 10. In 2009 the U.S. had a current account deficit of
$420 billion. This means these transactions created out-payments from the
United States greater than in-payments to the United States.
2. Capital and Financial Account- summarizes U.S. international asset
transactions which consist of two separate accounts.
 Capital Account- mainly measures debt forgiveness. It is a net account or
one that can be either + or -. The $3 billion listed in item 11 tells us that in
2009 Americans forgave $3 billion more of debt owed to them by
foreigners than foreigners forgave debt owed to them by Americans. The (-)
sign indicates a debit, or out-payment.
 Financial Account- summarizes international asset transactions having to do
with purchases and sales of real or financial assets. Line 12 lists the amount
of foreign purchases of assets in the U.S. It has a (+) sign because any
purchase of an American owned asset by a foreigner generates a flow of
money toward the American who sells the asset. Line 13 lists U.S.
purchases of assets abroad. These have a (-) sign because such purchases
generate a flow of money from the Americans who buy foreign assets
toward the foreigners who sell them those assets. Items 12 and 13
combined yielded a $423 billion balance on the financial account for 2009,
line 14.
The balance on the capital and financial account, line 15, is $420 billion. It is the
sum of the $3 billion deficit on the capital account and the $423 billion surplus on
the financial account. Observe that this $420 billion surplus in the capital and
financial account equals the $420 billion deficit in the current account. The two
numbers always equal, or balance.
Why the Balance?
The balance on the current account and the capital and financial account must
always sum to zero because any deficit or surplus in the current account
automatically creates an offsetting entry in the capital and financial account.
People can only trade one of two things with each other: currently produced
goods and services or preexisting assets. Therefore, if trading partners have an
imbalance in their trade of currently produced goods and services, the only way
to make up for that imbalance is with a net transfer of assets from one party to
another.
Specifically, current account deficits simultaneously generate transfer of assets to
foreigners, while current account surpluses automatically generate transfers of
assets from foreigners.
Flexible Exchange Rates
There are two pure types of exchange rate systems.
 A flexible or floating exchange rate system- through which demand and
supply determine exchange rates and in which no government intervention
occurs.
 A fixed exchange rate system- through which governments determine
exchange rates and make necessary adjustments in their economies to
maintain those rates.
We will be looking at flexible exchange rates. Let’s examine the rate, or price, at
which U.S. dollars might be exchanged for British pounds. In figure 38.1 we show
demand Dl of pounds and supply Sl of pounds in the currency market. The
demand for pounds curve is down-sloping because all British goods and services
will be cheaper to the U.S. if pounds become less expensive to the U.S. That is, at
lower dollar prices for pounds, the U.S. can obtain more pounds and therefore
more British goods and services per dollar. The supply of pounds curve is upsloping because the British will purchase more U.S. goods when the dollar price of
pounds rises. The intersection of the supply curve and the demand curve will
determine the dollar price of pounds. Here, that price, or exchange rate, is $2 =
1£.
Depreciation & Appreciation
An exchange rate determined by market forces can, and often does, change daily
like stock and bond prices. These exchange rates can be found in a good daily
newspaper or on the internet. When the dollar price of pounds rises, for example,
from $2 =1£ to $3 = 1£, the dollar has depreciated relative to the pound, and the
pound has appreciated relative to the dollar. When a currency depreciates, more
units of it (dollars) are needed to buy a single unit of some other currency
(pounds). When the dollar price of pounds falls, for example, from $2=1£ to
$1=1£, the dollar has appreciated relative to the pound. When a currency
appreciates, fewer units of it (dollars) are needed to buy a single unit of some
other currency (pounds). In our U.S.-Britain example, depreciation of the dollar
means an appreciation of the pound, and vice versa. When the dollar price of a
pound jumps from $2 = 1£ to $3= 1£, the pound has appreciated relative to the
dollar because it takes fewer pounds to buy $1. At $2=1£, it took £½ to buy $1; at
$3=1£, it takes only £⅓ to buy $1.
In general, the relevant terminology and relationships between the U.S. dollar and
another currency are as follows.
 If the demand for pounds increases or the supply of pounds decreases, the
pound will appreciate. This means that anything which raises the dollar
price of a pound will cause it to get stronger.
 If the demand for pounds decreases or the supply of pounds increases, the
pound will depreciate. This means that anything which lowers the dollar
price of a pound will cause it to get weaker.
Determinants of Exchange Rates
What factors would cause a nation’s currency to appreciate or depreciate in the
market for foreign exchange? These factors will shift the demand or supply curve
for a certain currency.
1. Changes in Tastes- Any change in consumer tastes or preferences for the
products of a foreign country may alter the demand for that nation’s
currency and change its exchange rate. For example, if technological
advances in U.S. wireless phones make them more attractive to British
consumers and businesses, then the British will supply more pounds in the
exchange market to purchase more U.S. wireless phones. The supply of
pounds will shift right, causing the pound to depreciate and the dollar to
appreciate. In contrast, the U.S. demand for pounds curve will shift to the
right if British woolen apparel becomes more fashionable in the United
States. So the pound will appreciate and the dollar will depreciate.
2. Relative Income Changes- A nation’s currency is likely to depreciate if its
growth of national income is more rapid than that of other countries. As
total income rises in the U.S., people there buy both more domestic goods
and more foreign goods. If the U.S. economy is expanding rapidly and the
British economy is stagnant, U.S. imports of British goods, and therefore
U.S. demands for pounds will increase. The dollar price of pounds will rise,
so the dollar will depreciate.
3. Relative Inflation Rate Changes- Other things equal, changes in the relative
rates of inflation of two nations change their relative price levels and alter
the exchange rate between their currencies. The currency of the nation
with the higher inflation rate tends to depreciate. For example, if inflation is
zero in Britain and 5% in the U.S., American consumers will seek out more
of the now relatively lower-priced British goods, increasing the demand for
pounds. British consumers will buy less of the now relatively higher-priced
U.S. goods, reducing the supply of pounds. This combination of increased
demand for pounds and reduced supply of pounds will cause the pound to
appreciate and the dollar to depreciate.
4. Relative Interest Rates- Changes in relative interest rates between two
countries may alter their exchange rate. Suppose that real interest rates
rise in the U.S. but stay constant in Britain. British citizens will then find the
U.S. a more attractive place in which to loan money directly or loan money
indirectly by buying bonds. To make these loans, they will have to supply
pounds in the foreign exchange market to obtain dollars. The increase in
the supply of pounds results in depreciation of the pound and appreciation
of the dollar.
5. Changes in Relative Expected Returns on Stocks, Real Estate, and
Production Facilities- International investing extends beyond buying just
foreign bonds. To make the investments, investors in one country must sell
their currencies to purchase the foreign currencies needed for the foreign
investments. Suppose investing in England suddenly becomes more popular
due to a more positive outlook regarding expected returns on stocks, real
estate, and production facilities there. U.S. investors will sell U.S. assets to
buy more assets in England. U.S. investors will exchange their dollars for
pounds, which are then used to purchase the British assets. The increased
demand for pounds will cause it to appreciate and therefore the dollar will
depreciate relative to the pound.
6. Speculation- Currency speculators are people who buy and sell currencies
with an eye toward reselling or repurchasing them at a profit. Suppose
speculators expect the U.S. economy to grow more rapidly than the British
economy and to experience more rapid inflation as a result. These
expectations translate into the anticipation that the pound will appreciate
and the dollar will depreciate. Speculators who are holding dollars will
therefore try to convert them into pounds. This effort will increase the
demand for pounds and cause the dollar price of pounds to rise. A selffulfilling prophecy occurs. The pound appreciates and the dollar
depreciates because speculators act on the belief that these changes will in
fact take place.
Table 38.2 has more illustrations of the determinants of exchange rates.
Recent U.S. Trade Deficits
As shown in figure 38.4a, the United States has experienced large and persistent
trade deficits in recent years. These deficits rose rapidly between 2001 and 2006
before declining when consumers and businesses greatly curtailed their purchase
of imports during the recession of 2007-2009. Economists expect the trade
deficits to expand, absolutely and relatively, toward prerecession levels when the
economy recovers and U.S. income and imports again rise.
Causes of the Trade Deficits
 First, the U.S. economy expanded more rapidly between 2001 and 2007
than the economies of several U.S. trading partners. The strong income
growth enabled Americans to greatly increase their purchases of imported
products.
 Another factor explaining large trade deficits is the enormous U.S. trade
imbalance with China. In 2007 the U.S. imported $257 billion more than it
exported to China. The U.S. is China’s largest export market, and although
China has greatly increased its imports from the U.S., its standard of living
has not yet risen sufficiently for its households to afford large quantities of
U.S. goods. Adding to the problem, China’s government has fixed the
exchange rate of its currency, the yuan, to a basket of currencies that
includes the U.S. dollar. Therefore, China’s large trade surpluses have not
caused the yuan to appreciate much against the dollar.
 Another factor underlying the large U.S. trade deficits is a continuing trade
deficit with oil-exporting nations, or OPEC.
 A declining savings rate has also contributed to the large trade deficits.
Last Word: Speculation in Currency Markets