Balance of payments

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International Finance
and the Foreign
Exchange Market
Open economy An economy that has interactions in
trade or finance with other countries.
Closed economy An economy that has no interactions in
trade or finance with other countries.
Balance of payments The record of a country’s trade
with other countries in goods, services, and assets.
The following table shows the balance of payments
for the United States in 2010.
Notice that the table contains three “accounts”: the
current account, the financial account, and the
capital account.
CURRENT ACCOUNT
The Balance of Payments,
2010 (billions of dollars)
Exports of goods
$1,289
Imports of goods
−1,935
−646
Balance of trade
Exports of services
549
Imports of services
−403
Balance of services
146
Income received on investments
663
Income payments on investments
−498
Net income on investments
165
Net transfers
−136
Balance on current account
−471
FINANCIAL ACCOUNT
Increase in foreign holdings of assets in
the United States
Increase in U.S. holdings of assets in
foreign countries
Balance on financial account
BALANCE ON CAPITAL ACCOUNT
Statistical discrepancy
Balance of payments
1,259
−1,005
254
0
217
0
The sum of the
balance of trade
and the balance
of services equals
net exports.
(a) Trade flows for the US
(in billions of dollars)
(b) Trade flows for Japan
(in billions of dollars)
In 2010, the United States ran a trade deficit with all its major trading partners
and with every region of the world except for Latin America.
Japan ran trade deficits with China, Latin America, and the Middle East, and it ran
trade surpluses with the United States, Europe, and Asia. In each panel, the green
arrows represent exports from the United States or Japan, and the red arrows
represent imports.
Balance of Payments
• Current account transactions:
all payments (and gifts) related to the purchase
or sale of goods and services and income flows
during the current period
• Four categories:
• Merchandise trade
(import and export of goods)
• Service trade
(import and export of services)
• Income from investments
• Unilateral transfers
(gifts to and from foreigners)
Net Exports = the Balance of Trade +
the Balance of Services
The current account balance also includes net income on
investments and net transfers. Because these items are
relatively small, it is often a convenient simplification to
think of net exports as being equal to the current
account balance.
Balance of Payments
• Financial account transactions:
transactions that involve changes in the ownership
of real and financial assets
• The financial account includes both
• direct investments by foreigners in
the U.S. and by Americans abroad, and,
• loans to and from foreigners.
• Under a pure flexible-rate system, official
reserve transactions are zero; therefore:
• a financial-account deficit implies
a capital-account surplus.
• a financial-account surplus implies
a capital-account deficit.
The Financial Account
There is a capital outflow from the United States when
an investor in the United States buys a bond issued by a
foreign company or government or when a U.S. firm
builds a factory in another country.
There is a capital inflow into the United States when a
foreign investor buys a bond issued by a U.S. firm or by
the government or when a foreign firm builds a factory
in the United States.
Another way of thinking of the balance on the financial
account is as a measure of net capital flows, or the
difference between capital inflows and capital outflows.
Balance of Payments
• Capital account transactions:
transactions that involve relatively minor
transactions, such as migrants’ transfers and
sales and purchases of non-produced, nonfinancial assets such as a copyright, patent,
trademark, or right to natural resources
• Prior to 1999, the capital account recorded all
the transactions included now in both the
financial account and the capital account. In
other words, capital account transactions went
from being a very important part of the balance
of payments to being a relatively unimportant
part.
Balance of Payments
• Balance of payments:
accounts that summarize the transactions
of a country’s citizens, businesses, and
governments with foreigners
• Imports create a demand for foreign currency
(and a supply of the domestic currency) and are
recorded as a debit item.
• Exports create a supply of foreign
currency (and demand for the domestic currency)
and are recorded as a credit item.
Why Is the Balance of Payments Always
Zero?
The sum of the current account balance, the financial
account balance, and the capital account balance equals the
balance of payments.
To make the balance on the current account equal the
balance on the financial account, we include an entry called
the statistical discrepancy.
Changes in foreign holdings of dollars are known as official
reserve transactions.
A current account deficit must be exactly offset by a
financial account surplus, leaving the balance of payments
equal to zero.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
11 of 39
Balance of Payments
• Under a pure flexible rate system, the foreign
exchange market will bring the quantity
demanded and the quantity supplied into
balance, and as a result, it will also bring the
total debits into balance with the total
credits.
Current Acct & Net Foreign Investment
Current Account as % of GDP
+2
surplus (+) or deficit (-)
0
-2
-4
-6
1978
1983
1988
1993
1998
2003
2008
2003
2008
Net Foreign Investment as % of GDP
surplus (+) or deficit (-)
+4
+2
0
-2
1978
1983
1988
1993
1998
• Under a flexible exchange rate system the inflow and
outflow of capital exert a major impact on current
account balances.
Labatt’s beer is produced in Canada.
In 1990, in Ontario, a six-pack of Labatt’s beer sold
for $6.60 Canadian.
Across the border in
Michigan, a six pack of the
same beer was on sale for
$2.75 U.S.
At the time, the exchange
rate was
$0.75 U.S. = $1.00 Canadian.
In Ontario, $6.60 Canadian.
In Michigan, $2.75 U.S.
$0.75 U.S. = $1.00 Canadian.
1. How much would it cost in U.S.
currency to buy the beer in Ontario?
2. How much would it cost in Canadian
currency to buy the beer in Michigan?
3. Is there an arbitrage opportunity?
4. Where would you buy and where would you sell?
5. How much profit could you expect on a six-pack?
$6.60
x ($2.93
.75 = $4.95
US
$4.95
$2.75
= $2.20
Canadian)
$2.75
.75
= $3.67
Can
Buy in/-Michigan,
sell
inUS
Ontario
Number of 1 country’s currency that
is equal to 1 unit of another country’s
$1 = 0.6292 €
$1 = 0.755 €
1€ = 1.5892 $
1€ = 1.3245 $
$1 = 0.5051 £
$1 = 0.6787 £
1£ = 1.9797 $
1£ = 1.4734 $
Foreign Exchange Market
• Market where different currencies are
traded, one for another.
• The exchange rate enables people in one
country to translate the prices of foreign
goods into units of their own currency.
• An appreciation of a nation’s currency will
make foreign goods cheaper.
• A depreciation of a nation’s currency will
make foreign goods more expensive.
How many $$ does it take
to get one of theirs?
Currency
Pair
Price
EUR/USD
1.3548
How many $$ you get
with one of theirs?
Currency
Pair
Price
USD/EUR
0.7381
USD/AUD
1.0987
USD/GBP
0.6112
USD/JPY
103.0550
CAD/USD 0.9404
USD/CAD
1.0636
CHF/USD
USD/CHF
0.9080
AUD/USD 0.9098
GBP/USD
1.6365
JPY/USD
0.0097
1.1013
Currency
Last Trade
U.S. $
¥en
Euro
U.S. $
¥en
12/04
Euro
12/04
1 0.009328
Can $
12/04
U.K. £
12/04
Aust $
12/04
SFranc
12/04
1.222
0.7705
1.733
0.7403
0.7894
1
131
82.59
185.8
79.36
84.62
0.8181 0.007632
1
0.6303
1.418
0.6057
0.6458
107.2
Can $
1.298
0.01211
1.586
1
2.249
0.9608
1.025
U.K. £
0.577 0.005382
0.7053
0.4446
1
0.4272
0.4555
Aust $
1.351
0.0126
1.651
1.041
2.341
1
1.066
SFranc
1.267
0.01182
1.548
0.976
2.195
0.9378
1
Currency
$
Appreciate
/
Depreciate
Yahoo
April 2008
Yahoo April 2005
U.S. $
1
1
¥en
Euro
Can $
U.K. £
Aust $
103.21
0. 6292
1.0197
0.5051
1.0561
107.293
0. 7689
1.244
0.5232
1.2943
SFranc
1.0125
1.1879
Yahoo
Mar 2004
Yahoo
Dec 2003
1
1
105.6 107.2
0.8237 0.8181
1.31 1.298
0.5506 0.577
1.337 1.351
1.287
1.267
Text
Oct 2002
1
123.3
1.01
1.5987
0.6391
1.84
1.49
Determinants of the Exchange Rate
• flexible rate system - the exchange rate is
determined by supply and demand.
• The dollar demand for foreign exchange
originates from American demand for foreign
goods, services, & assets (real or financial).
• The supply of foreign exchange originates from
sales of goods, services, & assets from
Americans to foreigners.
There are three sources of foreign currency demand
for the U.S. dollar:
1. Foreign demand for goods and services produced in
the United States.
2. Foreign investment in the United States either
through foreign direct investment—buying or
building factories or other facilities in the United
States—or through foreign portfolio investment—
buying stocks and bonds issued in the United States.
3. Currency traders who believe that the value of the
dollar in the future will be greater than its value
today.
Changes in the Exchange Rate
•
Determinants:
1. A change in national income (relative to
trading partners) people buy more, or
less of everything.
2. A change in the inflation rate in one
country.
a. Higher rate decreases demand
b. Lower demand - depreciation
3. A change in interest rates (relative to
rates abroad).
a. High rates attract money
b. Currency appreciates
4. Changes in tastes
Foreign Exchange
Market Equilibrium
• If incomes increase in the
foreign exchange
United States, U.S. imports of (for pounds)
foreign goods and services will
grow.
• The increase in imports will
increase the demand for
pounds in the foreign exchange $1.80
market causing the dollar
price of the pound to rise from $1.50
$1.50 to $1.80.
Dollar price of
S(sales to
foreigners)
b
a
D2
D1
Q1 Q2
Quantity of
foreign exchange
(pounds)
Inflation With
Flexible Exchange Rates
S
• If the price level in the U.S.
increased by 50 % …
the U.S. demand for British
goods (and pounds) would
increase (relatively cheap).
Since U.S. exports to Britain
would decline and thereby
cause the supply of pounds to
fall.
• These forces would cause the
dollar to depreciate relative
to the pound.
2
Dollar price of
foreign exchange
(for pounds)
S1
$2.25
b
$1.50
a
D2
D1
Q1
Quantity of
foreign exchange
(pounds)
The Fall and Rise and Fall of the Dollar
1. Low U.S. interest rates have played a role in the declining value of the dollar.
2. Many investors and some central banks became convinced that the value of the
dollar was too high in 2002 and that it was likely to decline in the future.
The depreciation of the dollar:
1. bad news for U.S. tourists and for anyone in the United States importing foreign
goods and services.
2. good news for U.S. firms exporting goods and services
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
26 of 39
Peso – Appreciation or Depreciation?
1. The US reduces tariffs on Mexican products.
2. Mexico encounters severe inflation.
3. Deteriorating political relations reduce American
tourism in Mexico.
4. The US economy moves into a severe recession
5. A bartender puts a lime in a Corona and beer
sales jump
6. The Mexican government encourages American
firms to invest in Mexican oil fields
7. A large federal government budget deficit raises
interest rates in the US
Euro – Appreciation or Depreciation?
1. An American importer purchases a shipload of
Bordeaux wine.
2. BMW decides to build an assembly plant in LA
3. A CVCC student decides to spend a year studying
at the Sorbonne.
4. A Spanish manufacturer exports machinery to
Morocco on an American freighter.
5. The US incurs a balance of payments deficit in
its transactions with Belgium.
6. A US government bond held by an Italian citizen
matures.
7. It is widely believed that the international value
of the Euro will fall in the near future.
Monetary Policy & the Exchange Rate
• An unanticipated shift to a more restrictive
monetary policy will:
• raise the real interest rate,
• reduce the rate of inflation, and,
• at least temporarily, reduce aggregate
demand and the growth of income;
• causing an appreciation in domestic currency.
• the currency appreciation (with shift the current
account toward a deficit).
• An unanticipated shift to more expansionary
monetary policy will cause the opposite:
•
•
•
•
lower interest rates, and,
an outflow of capital;
leading to a currency depreciation, and,
a shift toward a current account surplus.
Fiscal Policy & the Exchange Rate
• An expansionary fiscal policy may cause:
•
•
•
•
higher interest rates,
which can increase in foreign investment,
causing a currency appreciation, and,
a decrease in exports.
1.
A depreciation in the value of the U.S. dollar would
a. encourage foreigners to travel on American owned airlines.
b. make U.S. goods more expensive to foreign consumers.
c. decrease the number of dollars it takes to buy a Swiss franc.
d. make it more expensive for U.S. citizens to travel abroad.
3.
a.
b.
c.
d.
A nation’s trade deficit will tend to expand when
its economy is expanding.
its economy is shrinking.
its investment environment is less attractive to foreigners.
both b and c above are true.
4.
Under a system of flexible exchange rates, an increase in
demand for a nation’s currency in the foreign exchange market will
a. cause the nation’s currency to appreciate.
b. make it more expensive for the nation to import goods.
c. cause the nation’s balance on current account to shift toward a
surplus.
d. make it less expensive for foreigners to buy the nation’s goods.
5.
Under a system of flexible exchange rates, which of the
following will most likely cause a nation’s currency to appreciate on the
foreign exchange market?
a. a decrease in domestic interest rates
b. an increase in foreign interest rates
c. domestic inflation of 10 percent while the nation’s trading partners
are experiencing stable prices
d. stable domestic prices while the nation’s trading partners are
experiencing 10 percent inflation
6.
Suppose a German-produced car becomes very popular in the
United States. This would tend to
a. affect the U.S. balance of payments but not the balance of trade.
b. reduce any existing balance of trade deficit in the United States.
c. increase a balance of trade surplus in the United States.
d. increase a balance of trade deficit in the United States.
9.
If the dollar price of the euro goes from $1 to 90 cents, the
euro has
a. appreciated, and Europeans will find U.S. goods cheaper.
b. appreciated, and Europeans will find U.S. goods more expensive.
c. depreciated, and Europeans will find U.S. goods cheaper.
d. depreciated, and Europeans will find U.S. goods more expensive.
10. Which of the following would cause
the American demand for foreign
exchange (pounds) to shift from D1 to
D 2?
a. an increase in the U.S. real interest
rate
b. higher inflation in Britain than in
the United States
c. higher income growth in Britain than
in the United States
d. an increased level of vacation travel
to Britain by Americans
11. Which of the following would cause the demand for foreign
exchange (pounds) to shift from D1 to D2?
a. an increase in the real interest rate in Britain relative to the US
b. higher inflation in Britain than in the United States
c. higher income growth in Britain than in the United States
d. an increase in the number of British citizens vacationing in the US
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