Chapter 6 -- International
Finance and the Economy
Measures of international finance.
Exchange rates, how they’re
determined, and effects upon
economy.
Closer look at theory of Net
Exports, and the role of exchange
rates within them.
Measures of
International Finance
Record of transactions between
American residents and residents
of other countries over a flow
interval.
Current Account
Capital Account
Balance of Payments
The Current Account
Current Account =
{Exports + Foreign Transfers
to US + Income earned from
American holdings of investments
abroad}
-- {Imports + US Transfers to
Foreigners + Income earned from
foreign investments in US}
The Current Account:
Interpretation
Items in the first set of { } -- current
account inflows, ways that dollars
enter into the US from international
transactions in the current account.
Items in the second set of { } -- current
account outflows, ways that dollars
leave the US from international
transactions in the current account.
The Current Account:
Characteristics
Comprehensive measure of the
Balance of Trade (NX is a close
approximation).
The Capital Account
Capital Account =
{Net Foreign Purchases of
US Assets by foreign residents}
- {Net US Purchases of
Foreign Assets by US residents}
Capital Account =
{Capital Account Inflows}
- {Capital Account Outflows}
Can be interpreted as “net private
borrowing” from the foreign sector.
The Balance of Payments (BOP)
Balance of Payments outcome
= Current Account + Capital Account
Represents “what’s left over” after all
international transactions between residents
of the US (other than government) and
residents of other countries (other than
government) during a flow period.
Positive sign: Surplus, Negative Sign: Deficit
Balance of Payments deficits – financed by
government borrowing from foreign sector.
The Recent US Record -International Transactions
Current Account < 0
Capital Account > 0, but less than
|Current Account|
Balance of Payments < 0
Negative Balance of Payments –
financed by US borrowing from
foreign sector.
Balance of Payments and
Government Borrowing
Resulting equation:
BOP + (Net Government Borrowing
from Foreign Sector) = 0
 (Current Account + Capital Account)
+ (Net Government Borrowing
from Foreign Sector) = 0
 (Current Account)
+ (Total Net Borrowing from
Foreign Sector) = 0
The Balance of Payments
and the “Magic Equation”
“Magic Equation”: S + (T – G) + (-NX) = I.
Balance of Payments equation: 
Current Account + (Total Net Borrowing
from Foreign Sector) = 0.
Also recall that
NX  (Current Account).
Substitute the two expressions into Macro
Identity for (-NX)
 S + (T – G) + (Total Net Borrowing from
Foreign Sector) = I.
Exchange Rates
(Nominal) Exchange Rate (e’) -- the
amount of foreign currency
needed to be exchanged for one
(US) dollar.
Also known as the “value of the
dollar”.
Conversion Ratio, in units of
(foreign currency)/(US dollar)
Types of Exchange Rates
Bilateral Exchange Rates -exchange rates between the US
and an individual country.
Multilateral (Trade Weighted)
Exchange Rate -- weighted
average of bilateral exchange rates
expressed as an index (macro
measure of exchange rate).
Exchange Rate Changes
e’  price of American goods and
services to foreigners
 price of foreign goods and
services to Americans
e’  price of American goods and
services to foreigners
 price of foreign goods and
services to Americans
The Real Exchange Rate (e)
e = (P)(e’)
(Pf)
P = US Price Level
Pf = Foreign Price Level
Key cause of net exports.
The Real Exchange Rate:
An Interpretation
e = (P)(e’)
(Pf)
Units of e:
= ($/Quantity)(Foreign Currency/$)
(Foreign Currency/Quantity)
= (Foreign Currency/Quantity)
(Foreign Currency/Quantity)
The Real Exchange Rate
and Price Comparison
e = (P)(e’)
(Pf)
It consists of the ratio of the price
level of American goods and
services -- expressed in units of
foreign currency -- to the price
level of (corresponding) foreign
goods and services.
The Real Exchange Rate
and Net Exports
e (P, Pf, or e’)  substitution away
from the relatively more expensive US
goods and services  (US) Exports,
(US) Imports  NX
e (P, Pf , or e’)  substitution into
the relatively cheaper US goods and
services  Exports, Imports  NX
Exchange Rate Regimes
Fixed (Pegged) Exchange Rates -e’ fixed, unless changed by
economic policy.
Floating Exchange Rates -- e’
determined by natural forces in the
foreign exchange market.
Managed Float -- floating e’ with
occasional Treasury/Federal
Reserve intervention.
The Foreign Exchange
Market -- Determination of e’
The Foreign Exchange Market -the demand and supply for dollars
for use in international
transactions.
Concepts to Understand
Foreign Exchange Behavior
Items (goods, services, financial
assets) are priced in a country’s
home currency.
If one wishes to buy from another
country, he/she must convert from
their own currency to the currency
of the country selling the item.
More Concepts:
Foreign Exchange
The nominal exchange rate (e’)
specifies the ratio of conversion.
One exchange rate (e’) is the
conversion ratio for all foreign
transactions (goods, services,
financial assets) – Law of One
Exchange Rate.
The Demand for Dollars
The Demand for Dollars -foreigners demand for US dollars,
to buy American goods, services,
or financial assets.
Inversely related to the nominal
exchange rate, with other causes
(shift variables) as well.
The Supply of Dollars
The Supply of Dollars -Americans supplying dollars to the
foreign exchange market, in order
to buy foreign goods, services, or
financial assets.
Positively related to the nominal
exchange rate, with other causes
(shift variables) as well.
Foreign Exchange
Market Equilibrium
Equilibrium exchange rate
(foreign
currency)/(US$)
-- “price of dollars.”
At equilibrium:
Current Account
+ Capital Account = 0
At equilibrium, the
Balance of Payments = 0.
Example 1 -- Increase in US
Interest Rates (i)
Increase in i leads to substitution away
from foreign financial assets to US
financial assets.
Foreigners substitute  Demand for
Dollars Increases (curve shifts
rightward).
Americans Substitute  Supply of
Dollars (Abroad) Decreases (curve
shifts leftward).
As a result, the equilibrium exchange
rate (e’*) Increases.
Example 2 -- Increase in
Foreign Interest Rates (if)
Increase in if leads to substitution away
from US financial assets to foreign
financial assets.
Foreigners substitute  Demand for
Dollars Decreases (curve shifts
leftward).
Americans Substitute  Supply of
Dollars (Abroad) Increases (curve
shifts rightward).
As a result, the equilibrium exchange
rate (e’*) Decreases.
Speculation -- Expectations
of Exchange Rate Changes
Example 3 -- consider the exchange
rate in units of foreign currency
(abbreviation -- fcu) per dollar.
e’ = (5 fcu)/($1), and you expect
(correctly) that it will decrease in the
future to (4 fcu)/($1).
Response -- sell dollars now, buy them
back when “cheaper.”
Capital Gains in the
Foreign Exchange Market
Continue example, start with $100.
Step #1 -- buy foreign currency at
the current exchange rate.
(100$)[(5 fcu)/($1)] = 500 fcu.
Step #2 -- convert back to dollars
when e’ decreases in the future.
(500 fcu)[($1)/(4 fcu)] = $125.
Capital gain of $25.
Floating Exchange Rates
Advantages
-- At market equilibrium, Balance of
Payments = 0, i.e.  current account +
capital account = 0.
-- Federal Reserve does not need to
participate in foreign exchange market,
it can use the money supply to focus
solely on domestic policy.
Floating Exchange Rates
(Continued)
Disadvantages
-- Fluctuating exchange rate is
disruptive to International Trade
(exchange rate risk).
-- Exchange rates can fluctuate a
great deal, especially due to
speculation (speculative bubbles).
Fixed Exchange Rates
Advantages
-- exchange rate is constant,
stability in International Trade
(exchange rate risk = 0).
Fixed Exchange Rates
(Continued)
Disadvantages
-- Federal Reserve must intervene constantly
in the foreign exchange market to keep BOP
= 0  loses control of money supply.
-- Or country faces distorted Balance of
Payments position (negative or positive)
-- Fed might be forced into contractionary
monetary policy to raise i* and increase e’*
to the fixed rate.
Exchange Rate Regimes -Overall
Ideal system: floating exchange
rates which do not exhibit much
movement.
Actual system (US):
Managed Float -- floating exchange
rates with occasional Federal
Reserve intervention.
Exchange Rates and
the Macro Models
Review concepts:
-- Real exchange rate (e),
e = (P)(e’)/(Pf).
-- Real exchange rate is inversely
related to net exports,
i.e. e  NX.
Causes of Net Exports -Fixed and Floating e’
Foreign Output or Income (Yf)
US Output or Income (Y)
Barriers to Trade
Causes of Net Exports,
Continued
Real Exchange Rate (e)
-- US Price Level (P),
P  e  NX
-- Foreign Price Level,
Pf   e  NX
-- Nominal Exchange Rate (e’)
e’  e  NX
Further Decomposition -Causes of Net Exports
Real Exchange Rate (e)
...
-- Nominal Exchange Rate (e’)
(a) US interest rate (i)
i  e’*  e  NX
(b) Foreign interest rate (if)
if  e’*  e  NX
(c) Expectations of Future e’
Exchange Rates
and the IS-LM Model
Note -- causes (a), (b), and (c)
apply only to floating exchange
rates.
Fixed Exchange Rates and the
IS-LM Model -- e’ inflexible, cause
of autonomous Net Exports, shifts
IS curve.
Floating Exchange Rates
and the IS-LM Model
Since the nominal interest rate is a
cause of the nominal exchange
rate and Net Exports, this behavior
affects the slope of the IS curve.
 Under floating exchange rates:
i*  C, I, NX.
Additional response to interest
rate change  greater elasticity
 flatter IS curve.
Floating Exchange Rates
and Policy Effectiveness
Flatter IS curve under floating
exchange rates makes fiscal policy
less effective and monetary policy
more effective.
Recent Developments –
Exchange Rates
1971-73: US Transitions From System of
Fixed Exchange Rates to Floating Exchange
Rates Against Major Industrialized
Economies.
2006-: US pressuring China to convert from
Fixed Exchange Rate Regime to purely
Floating Exchange Rate (How Much Will
Yuan/$ Exchange Rate Decrease as a
Result?).
Recent Developments -International Trade
Movement toward reducing or
removing trade barriers
-- General Agreement on Tariffs
and Trade (GATT)
-- Replaced by World Trade
Organization (WTO)
Free Trade Agreements
Involving the US
-- North American Free Trade
Agreement (NAFTA), 1994.
-- Central American Free Trade
Agreement (CAFTA), 2005.
-- Free Trade Agreement of the
Americas (FTAA), Proposed.
More Developments
Creation of the European Union -economic bonding of major
European countries.
-- removing barriers to trade
among member nations
-- common currency (Euro)
-- one central bank for the
community
Challenges to the European Union
Uniform currency equivalent to fixed
exchange rate regime among member
nations.
To avoid large scale foreign borrowing
associated with fixed exchange rates and
BOP < 0, need for coordinated economic
policies among members.
Will nations with large budget deficits and
very sluggish economies (e.g. Greece)
accede to Germany’s fiscal-discipline based
economy?