Sally Meek
Sally.meek@pisd.edu
Revised by
Lori Leachman
leachman@econ.duke.edu
VII. Open Economy: International Trade and Finance

Balance of Payments Accounts

Foreign Exchange Market

Net Exports and capital flows

Links to financial and goods markets
(Handout page 1)
 The exchange rate is the price of one country’s money
in terms of another- there are 2 ways to report:
 E= foreign price of a dollar= #FC units/$1
 e=dollar price of foreign currency=$1/#FC units

Focus on money coming in as a credit (sell) and money going
out as a debit (buy) – or alternatively one person’s buy is
another person’s sell

2 major accounts: Current account and financial account
(Handout page 2)
BP = Current Account (CA) + Financial Account(FA) = 0
If BP≠0, then there is an official change in foreign currency
reserves (this role of official reserves is critical in fixed
exchange rate systems) so really
BP= CA + FA + ∆ off reserves = 0





Current account deficits must be offset by financial
account surpluses (increasing capital inflows)
(CA‹0)=( FA›0) so BP=0
Current account surpluses must be offset by financial
account deficits (increasing capital outflows)
(CA›0) = (FA‹0) so BP=0
(Handout page 2)

All transactions impact foreign currency markets of the
participants – because to buy or sell foreign goods or
asset you must exchange currency

Financial account transactions impact the loanable
funds market of the participants:
Capital inflows will increase the supply of loanable funds
(as foreigners buy bonds)
Capital outflows will decrease the supply of loanable
funds( as foreigners and domestic investors sell bonds)



Department of Commerce
 www.bea.gov – International Transactions

Examples of current articles (relatively)
 Bloomberg - March 19, 2009
 WSJ – September 11, 2008
 WSJ- Feb. 16, 2010

Balance of Payments – An Activity


(Handout pages 3 – 10)
2 groups (countries)
 Classifying transactions as current account or
financial/capital account
 Classifying transactions as inflows of money or outflows of
money
 Creating forex models to illustrate transactions impact on
currency value
 Creating loanable funds markets to illustrate impact on real
interest rates from financial/capital account transactions
Practice Questions: (page 11)
1.
Euros/$
=E
$/Euro
S$
=e
SEuros
S1
D$
D1
Q USD
increase D$=increase SFC; E rises or e falls
USD appreciates and the Euro depreciates
DEuros
QEuros
Practice Questions: (page 11)
2.
S$
SGD/$
=E
$/SGD
S1
SSGD
=e
D1
DSGD
D$
Q USD
Increase S$ = increase DSGD; E falls or e rises
USD depreciates and the SGD appreciates
QSGD
Practice Questions: (page 11)
3.
S$
Peso/$
$/Peso
SPeso
S1
D1
DPeso
D$
Q USD
USD depreciates and the Peso appreciates
QPeso
Practice Questions: (page 11)
4.
Yen/$
$/Yen
S$
SYen
S1
D$
D1
Q USD
USD appreciates and the Yen depreciates
DYen
QYen
Practice Questions: (page 11)
5.
SLF
Real Interest
rate
S1
DLF
Q Loanable Funds
Capital flows into the US (increased demand for dollars),
increasing the supply of loanable funds
and decreasing the real interest rate.
The US dollar would appreciate as more dollars
are demanded in order to purchase US government bonds.
Practice Questions: (page 11)
6.
S1
Real Interest
rate
SLF
DLF
Zambia’s Loanable Funds Market
Q
Capital flows out of Zambia, decreasing the supply of loanable funds
and increasing the real interest rate. Zambia’s currency would
depreciate as the currency is used to purchase other currencies.