Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Chapter 38 The Balance of Payments, Exchange Rates, and Trade Deficits
QUESTIONS
1. Do all international financial transactions necessarily involve exchanging one nation’s distinct
currency for another? Explain. Could a nation that neither imports goods and services nor exports
goods and services still engage in international financial transactions? LO1
Answer: The answer is almost certainly a yes. Only in rare cases would you find barter
exchanges (goods and services for other goods and services). Yes, they could engage in
financial transactions (the exchange of assets across countries).
2. Explain: “U.S. exports earn supplies of foreign currencies that Americans can use to finance
imports.” Indicate whether each of the following creates a demand for or a supply of European
euros in foreign exchange markets: LO1
a. A U.S. airline firm purchases several Airbus planes assembled in France.
b. A German automobile firm decides to build an assembly plant in South Carolina.
c. A U.S. college student decides to spend a year studying at the Sorbonne in Paris.
d. An Italian manufacturer ships machinery from one Italian port to another on a Liberian
freighter.
e. The U.S. economy grows faster than the French economy.
f. A U.S. government bond held by a Spanish citizen matures, and the loan amount is paid back to
that person.
g. It is widely expected that the euro will depreciate in the near future.
Answer: American exports lead to an increase in the foreign-currency bank deposit
holdings of Americans. These holdings will be decreased through American purchases of
imports. Hence, the foreign-currency assets earned through exports can be used to
finance imports.
(a) A demand for euros: The U.S. airline must purchase euros before purchasing the
Airbus planes.
(b) A supply of euros: The German automobile firm must purchase U.S. dollars, or
supply euros, before building the plant.
(c) A demand for euros: The U.S. college student must purchase euros before studying in
France.
(d) A supply of euros: The Italian manufacturer must purchase U.S. dollars, or supply
euros, to pay the Liberian freighter (which requires payment in U.S. dollars).
(e) A demand for euros: Since the U.S. economy grows faster than the French economy,
U.S. imports from France will grow faster than France's imports from the U.S. holding
everything else constant. To buy these additional French goods the U.S. will purchase
more (net) euros.
(f) A demand for euros: The U.S. pays the Spanish citizen in U.S. dollars. The Spanish
citizen then purchases euros so she has currency she can use in her home country.
(g) A supply of euros: Since individuals holding euros expect the currency to depreciate
in the near future they sell (supply) the euros today in an attempt to avoid the loss in the
future.
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
3. What do the plus signs and negative signs signify in the U.S. balance of payments statement?
Which of the following items appear in the current account and which appear in the capital and
financial account? U.S. purchases of assets abroad; U.S. services imports; foreign purchases of
assets in the United States; U.S. good exports, U.S. net investment income. Why must the current
account and the capital and financial account sum to zero? LO2
Answer: The plus sign (+) indicates a credit to the U.S. balance of payments. The
negative sign (-) indicates a debit the U.S balance of payments.
U.S. purchases of assets abroad: current account
U.S. services imports: current account
Foreign purchases of assets in the United States: capital and financial account
U.S. good exports: current account
U.S. net investment income: current account
The balance on the current account and the balance on 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 the other.
4. What are official reserves? How do net sales of official reserves to foreigners and net
purchases of official reserves from foreigners relate to U.S. balance-of-payment deficits and
surpluses? Explain why these deficits and surpluses are not actual deficits and surpluses in the
overall balance of payments statement. LO2
Answer: Official reserves consist of foreign currencies, certain reserves held with the
International Monetary Fund, and stocks of gold. These reserves are owned by
governments or their central banks.
Although the balance of payments must always sum to zero, in some years a net sale of
official reserves by a nation’s treasury or central bank occurs in the process of bringing
the capital and financial account into balance with the current account. In such years, a
balance-of-payments deficit is said to occur. This deficit is in a subset of the overall
balance statement and is not a deficit in the overall account. Remember, the overall
balance of payments is always in balance. But in this case the balancing of the overall
account includes sales of official reserves to create an inflow of dollars to the United
States. These net sales of official reserves in the foreign exchange market show up as a
plus (+) item on the U.S. balance of payments statement, specifically as foreign purchases
of U.S. assets.
In other years, the capital and financial account balances the current account because of
government purchases of official reserves from foreigners. The treasury or central bank
engineers this balance by selling dollars to obtain foreign currency, and then adding the
newly acquired foreign currency to its stock of official reserves. In these years, a balanceof-payments surplus is said to exist. This payments surplus therefore can be thought of as
either net purchases of official reserves in the balance of payments or, alternatively, as
the resulting increase in the stock of official reserves held by the government.
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Again, the balance of payments must always sum to zero. The net sale or purchase of
official reserves by a nation’s treasury or central bank occurs in the process of bringing
the capital and financial account into balance with the current account. The deficit or
surplus prior to the sale or purchase of reserves is a subset of the overall balance
statement and is not a deficit or surplus in the overall account.
5. Generally speaking, how is the dollar price of euros determined? Cite a factor that might
increase the dollar price of euros. Cite a different factor that might decrease the dollar price of
euros. Explain: “A rise in the dollar price of euros necessarily means a fall in the euro price of
dollars.” Illustrate and elaborate: “The dollar-euro exchange rate provides a direct link between
the prices of goods and services produced in the Euro Zone and in the United States.” Explain the
purchasing-power-parity theory of exchange rates, using the euro-dollar exchange rate as an
illustration. LO3
Answer: The dollar price of the euro is determined in a currency exchange market that
equates the supply euros with the demand for euros.
A factor that might increase the dollar price of the euro could be the result of an increase
in the demand for the euro or a decrease in the supply of the euro. (Examples) Increase
in Demand: More Airbus aircraft purchased by U.S. airlines. Decrease in supply: Less
Boeing aircraft purchased by European airlines.
A factor that might decrease the dollar price of the euro could be the result of an decrease
in the demand for the euro or an increase in the supply of the euro. (Examples)
Decrease in Demand: Less Airbus aircraft purchased by U.S. airlines. Increase in supply:
More Boeing aircraft purchased by European airlines.
If the euro appreciates relative to the dollar, it takes more dollars to purchase one euro.
At the same time, it takes fewer euros to buy a dollar, meaning that the euro price of
dollars has fallen.
Through exchange rates, residents of all trading nations can express the prices of goods
and services in other trading nations in terms of their domestic currencies. A change in
the exchange rate between any two countries will automatically lead to an adjustment in
the prices of all goods and services in both countries in terms of the other’s currency.
The determination of these price conversions represents the most basic and visible
function of exchange rates.
The purchasing power parity theory of exchange rates holds that exchange rates change
to equal the ratios of the nations’ price levels. If a certain item costs $100 in the U.S. and
50 euros in Germany, then the exchange rate should be $1 = 0.5 euros. It should take the
same amount of dollars to buy the item anywhere in the world if exchange rates adjust to
maintain purchasing power parity.
6. Suppose that a Swiss watchmaker imports watch components from Sweden and exports
watches to the United States. Also suppose the dollar depreciates, and the Swedish krona
appreciates, relative to the Swiss franc. Speculate as to how each would hurt the Swiss
watchmaker. LO3
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Answer: If the dollar depreciated relative to the franc, this means that it took more
dollars to get the francs necessary to buy a watch. In other words, the watch becomes
more expensive in dollar terms which would cause a decline in imported watches
purchased in the United States. Second, if the krona appreciated relative to the Swiss
franc, this is the same thing as saying that the franc depreciated relative to the krona. In
other words, it took more Swiss francs to buy parts in Sweden than it did previously. As
a result, the imported components for the watches became more expensive to the Swiss
company. The Swiss watchmaker was hurt twice. Its costs rose while its export sales
declined.
7. Explain why the U.S. demand for Mexican pesos is downsloping and the supply of pesos to
Americans is upsloping. Assuming a system of flexible exchange rates between Mexico and the
United States, indicate whether each of the following would cause the Mexican peso to appreciate
or depreciate, other things equal: LO3
a. The United States unilaterally reduces tariffs on Mexican products.
b. Mexico encounters severe inflation.
c. Deteriorating political relations reduce American tourism in Mexico.
d. The U.S. economy moves into a severe recession.
e. The United States engages in a high-interest-rate monetary policy.
f. Mexican products become more fashionable to U.S. consumers.
g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.
h. The rate of productivity growth in the United States diminishes sharply.
Answer: The U.S. demand for pesos is downward-sloping: When the peso depreciates in
value (relative to the dollar) the United States finds that Mexican goods and services are
less expensive in dollar terms and purchases more of them, demanding a greater quantity
of pesos in the process. The supply of pesos to the United States is upward-sloping: As
the peso appreciates in value (relative to the dollar), US. goods and services become
cheaper to Mexicans in peso terms. Mexicans buy more dollars to obtain more U.S.
goods, supplying a larger quantity of pesos.
(a)
The peso will appreciate. Mexican goods will become cheaper, so U.S. demand
for pesos for will increase.
(b)
The peso will depreciate. The high rate of inflation in Mexico (relative the U.S.)
will cause the price Mexican goods and services to increase (relative the U.S.). The U.S.
demand for pesos will fall. The supply of pesos will also increase because U.S. goods are
relatively cheaper. This will reinforce the depreciation of the peso.
(c)
The peso will depreciate. The reduction in U.S. tourism in Mexico reduces the
demand for pesos.
(d)
The peso will depreciate. The recession in the U.S. economy will reduce imports
from Mexico. This, in turn, will decrease the demand for the peso.
(e)
The peso will depreciate. The high interest rate in the U.S. will attract investors
from Mexico. This will increase the demand for U.S. dollars or the supply of pesos.
(f)
The peso will appreciate. U.S. consumers purchase more goods from Mexico.
This increases the demand for the peso.
(g)
The peso appreciates. The U.S. firms must purchase pesos to invest in Mexico.
This increases the demand for pesos.
(h)
The peso appreciates. The sharp decline in U.S. productivity reduces investment
in the U.S. by firms in Mexico. This decreases the supply of pesos.
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
8. Explain why you agree or disagree with the following statements: LO3
a. A country that grows faster than its major trading partners can expect the international value of
its currency to depreciate.
b. A nation whose interest rate is rising more rapidly than interest rates in other nations can
expect the international value of its currency to appreciate.
c. A country’s currency will appreciate if its inflation rate is less than that of the rest of the world.
Answer:
(a) This statement is true. If high rates of economic growth mean that the real incomes
of a country’s citizens are rising more rapidly than in other countries, its imports will
rise more than its exports. The demand for foreign currency by its citizens will
increase more than the supply of foreign currency, causing the value of the domestic
currency to decline.
(b) This statement is true. If domestic real interest rates are increasing more quickly than
those in other countries, foreign financial investment will be attracted to the country,
causing a rise in the supply of foreign currency and therefore an appreciation of the
country’s currency.
(c) This statement is true. If a country’s inflation rate is lower than rates in other
countries, the foreign prices of its products will decline relative to foreign-made
products, increasing exports and the supply of foreign currency. And the domestic
prices of foreign imports will increase relative to domestically made goods,
decreasing the demand for foreign currency. Both factors will cause the country’s
currency to appreciate.
9. “Exports pay for imports. Yet in 2009 the nations of the world exported about $379 billion
more of goods and services to the United States than they imported from the United States.”
Resolve the apparent inconsistency of these two statements. LO2
Answer: Exports pay for imports in the long run. In the short term, a country can import
more goods and services than it exports through external borrowing or the sale of
domestic assets to foreigners. Both activities increase the country’s capital account
balance and cause an inflow of foreign currency that can be used to finance import
purchases. Depletion of a country’s official reserves can also be used as a short-term
measure to finance imports, since the sale of foreign monies for domestic currency has
the same financial effect as an import transaction.
10. Diagram a market in which the equilibrium dollar price of 1 unit of fictitious currency zee (Z)
is $5 (the exchange rate is $5 =Z1). Then show on your diagram a decline in the demand for zee.
LO4
a. Referring to your diagram, discuss the adjustment options the United States would have in
maintaining the exchange rate at $5 = Z1 under a fixed-exchange-rate system.
b. How would the U.S. balance-of-payments surplus that is caused by the decline in demand be
resolved under a system of flexible exchange rates?
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Answer: See the graph illustrating the market for zees.
(a) The decrease in demand for zees from D1 to D2 will create a surplus (ab) of zees at
the $5 price. To maintain the $5 to Z1 exchange rate, the United States must
undertake policies to shift the demand-for-zee curve rightward or shift the-supply-of
zee curve leftward. To increase the demand for zees, the United States could use
dollars or gold to buy zees in the foreign exchange market; employ trade policies to
increase imports to U.S. from Zeeonia; or enact expansionary fiscal and monetary
policies to increase U.S. domestic output and income, thus increasing imports from
Zeeonia and elsewhere. Expansionary monetary policy could also reduce the supply
of Zees: Zeeons could respond to the lower U.S. interest rates by reducing their
investing in the United States. Therefore, they would not supply as many zees to the
foreign exchange market.
(b) Under a system of flexible exchange rates, the ab surplus of zees (the U.S. balance of
payments surplus) will cause the zee to depreciate and the dollar to appreciate until
the surplus is eliminated (at the $4 = Z1 exchange rate shown in the figure) because
U.S. would import more from Zeeonia and they would buy less from U.S. since zees
lost value.
11. Suppose that a country follows a managed-float policy but that its exchange rate is currently
floating freely. In addition, suppose that it has a massive current account deficit. Does it also
necessarily have a balance-of -payments deficit? If it decides to engage in a currency intervention
to reduce the size of its current account deficit, will it buy or sell its own currency? As it does so,
will its official reserves of foreign currencies get larger or smaller? Would that outcome indicate
a balance-of-payments deficit or a balance-of- payments surplus? LO4
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Answer: No, if the exchange rate is floating freely this market is adjusting to bring the
balance of payments into balance-no need for intervention (the current account deficit is
counter-balanced by the capital account). If this country wishes to reduce its current
account deficit it must make its currency ‘cheaper’ on the market. That is, it must
intervene in a way that causes its currency to depreciate, which will make this county’s
goods and services ‘cheaper’ on the international market. To accomplish this, the country
will purchase foreign currency (increasing the supply of home currency) and accumulate
more foreign reserves. Again, this country is not running a ‘balance of payments deficit’
because the exchange rate market is adjusting (interest rates are as well).
12. What have been the major causes of the large U.S. trade deficits in recent years? What are the
major benefits and costs associated with trade deficits? Explain: “A trade deficit means that a
nation is receiving more goods and services from abroad than it is sending abroad.” How can that
considered to be “unfavorable”? LO5
Answer:
(1) The U.S. economy has grown more rapidly than the economies of several major
trading nations. Thus U.S. exports have not kept pace with the rise in U.S. imports.
(2) Large trade deficits with China have contributed, with incomes in China too low
to result in a significant increase in imports from the U.S. (3) Increases in oil prices
have increased the trade deficit with OPEC nations. (4) Finally, a declining savings
rate in the U.S. (while investment has remained stable) has also contributed to the
trade deficit.
A trade deficit allows the Unites States to consume outside its production possibilities
curve. But, the gain in current consumption comes at the expense of reduced future
consumption.
A trade deficit is considered “unfavorable” because it must be financed by borrowing
from the rest of the world, selling off assets and dipping into foreign currency reserves.
Financing of the U.S. trade deficit has resulted in a larger foreign accumulation of claims
against U.S. financial and real assets than the U.S. claim against foreign assets.
13. LAST WORD Suppose Super D’Hiver—a hypothetical French snowboard retailer—wants to
order 5000 snowboards made in the United States. The price per board is $200, the present
exchange rate is 1 euro = $1, and payment is due in dollars when the boards are delivered in 3
months. Use a numerical example to explain why exchange-rate risk might make the French
retailer hesitant to place the order. How might speculators absorb some of Super D’Hiver’s risk?
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Answer: Because payment is due in three months in dollars, the French retailer might
worry that his anticipated price, which today is 1 million euros (5,000 boards at $200
when the exchange rate is 1 euro per dollar), might rise if the euro loses value relative to
the dollar. For example, at the end of three months the euro could fall in value to 1.5
euros = 1 dollar, and it would take 300 to obtain $200 rather than 200 euros. For 5,000
snowboards, this increases the retailer’s cost from 1,000,000 euros to 1,500,000 euros.
To protect against this risk, the retailer could purchase dollars forward—agreeing to pay a
specified price for dollars in three months. The retailer would know exactly what was
owed at the end of the three-month period, which would depend on the three-month
forward exchange rate, which may or may not be higher than the current rate. But at least
the retailer would know exactly how many euros will be needed at the end of three
months to obtain the $1 million for the snowboards.
Who would be willing to sign such a contract? It could be a speculator who is betting
that the value of the euro will rise against the dollar rather than fall. Therefore, the
speculator would be happy to sign a contract giving $1,000,000 for 1 million euros (or
whatever the forward agreement is), with the expectation that these 1 million euros will
be worth more than $1,000,000 in three months. Then, the speculator will have made a
profit, and the retailer will have eliminated the risk of not knowing how many euros will
be needed to obtain the $1 million for the snowboards. It is the speculator who has
assumed the risk in this example.
PROBLEMS
1. Alpha’s balance-of-payments data for 2010 are shown below. All figures are in billions of
dollars. What are the (a) balance on goods, (b) balance on goods and services, (c) balance on
current account, and (d) balance on capital and financial account? Suppose Alpha sold $10 billion
of official reserves abroad to balance the capital and financial account with the current account.
Does Alpha have a balance-of-payments deficit or does it have a surplus? LO2
Answer: a. $10; b. $15; c. $20; d. -$20; deficit.
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Feedback: Consider the following example. Alpha’s balance-of-payments data for 2010
are shown below. All figures are in billions of dollars. What are the (a) balance on goods,
(b) balance on goods and services, (c) balance on current account, and (d) balance on
capital and financial account? Suppose Alpha sold $10 billion of official reserves abroad
to balance the capital and financial account with the current account. Does Alpha have a
balance-of-payments deficit or does it have a surplus? LO2
(a) Balance on goods: Goods Exports minus Goods Imports (reported as a negative value
in table) = $40 - $30= $10 (surplus).
(b) Balance on goods and services: (Goods Exports minus Goods Imports) plus (Service
Exports minus Service Imports (reported as a negative value in table)) = ($40 - $30) +
($15 - $10) = $10 + $5 = $15 (surplus).
(c) Balance on current account: (Goods Exports minus Goods Imports) plus (Service
Exports minus Service Imports) plus Net Transfers (positive in table above because there
was a greater inflow than outflow of transfers) plus net investment income (negative in
table above because there was a greater outflow than inflow of investment income)= ($40
- $30) + ($15 - $10) + $10 +(-$5) = $20 (surplus).
(d) Balance on capital and financial account: Balance on the capital account plus (foreign
purchases of assets minus purchases of assets abroad = $0 + ($20 -$40) = -$20 (deficit)
If Alpha sells $10 billion of official reserves to balance the capital and financial account
with the current account, Alpha has a balance-of-payments deficit. This sale of official
reserves is a flow of Alpha 'dollars' back into the country of Alpha (foreign purchase of
Alpha's assets).
2. China had a $372 billion overall current account surplus in 2007. Assuming that China’s net
debt forgiveness was zero in 2007 (its capital account balance was zero), by how much did
Chinese purchases of financial and real assets abroad exceed foreign purchases of Chinese
financial and real assets? LO2
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
Answer: -$372
Feedback: Consider the following example. China had a $372 billion overall current
account surplus in 2007. Assuming that China’s net debt forgiveness was zero in 2007
(its capital account balance was zero), by how much did Chinese purchases of financial
and real assets abroad exceed foreign purchases of Chinese financial and real assets?
To offset the current account surplus, China would have to have a deficit in the capital
and financial account. Given the zero balance on the capital account, the surplus could
only be achieved if China’s purchases of financial and real assets abroad exceeded
foreign purchases of Chinese assets. The surplus foreign currency generated by the trade
surplus would either have to go to purchase foreign assets, or be accumulated as official
reserves in an amount equal to the current account surplus. Thus, the financial account
would be a deficit of $372 billion.
3. Refer to following table, in which Qd is the quantity of yen demanded, P is the dollar price of
yen, Qs is the quantity of yen supplied in year 1, and Qs' is the quantity of yen supplied in year 2.
All quantities are in billions and the dollar-yen exchange rate is fully flexible. LO3
a. What is the equilibrium dollar price of yen in year 1?
b. What is the equilibrium dollar price of yen in year 2?
c. Did the yen appreciate or did it depreciate relative to the dollar between years 1 and 2?
d. Did the dollar appreciate or did it depreciate relative to the yen between years 1 and 2?
e. Which one of the following could have caused the change in relative values of the dollar and
yen between years 1 and 2: (1) More rapid inflation in the United States than in Japan; (2) an
increase in the real interest rate in the United States but not in Japan; or (3) faster growth of
income in the United States than in Japan.
Answers: a. 115; b. 120; c. yen appreciated; d. dollar depreciated; (1) More rapid inflation
in the United States than in Japan.
Feedback: Consider the following example. Refer to following table, in which Qd is the
quantity of yen demanded, P is the dollar price of yen, Qs is the quantity of yen supplied
in year 1, and Qs' is the quantity of yen supplied in year 2. All quantities are in billions
and the dollar-yen exchange rate is fully flexible.
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
(a) What is the equilibrium dollar price of yen in year 1?
The equilibrium is 115, where Qd equals Qs (Qd = Qs =20).
(b) What is the equilibrium dollar price of yen in year 2?
The equilibrium is 120, where Qd equals Q's (Qd = Q's =15).
(c) Did the yen appreciate or did it depreciate relative to the dollar between years 1 and
2?
Since the price of the Yen increased (more dollars must now be given up to purchase one
more Yen), the Yen as appreciated.
(d) Did the dollar appreciate or did it depreciate relative to the yen between years 1 and
2?
Since the price of the Yen increased (more dollars must now be given up to purchase one
more Yen), the dollar depreciated.
(e) Which one of the following could have caused the change in relative values of the
dollar and yen between years 1 and 2: (1) More rapid inflation in the United States than
in Japan; (2) an increase in the real interest rate in the United States but not in Japan; or
(3) faster growth of income in the United States than in Japan.
(1) More rapid inflation in the United States than in Japan. The increase in the relative
price of goods and services in United States, as result of inflation, reduces the quantity of
Yen supplied to the market as Japanese consumers buy more 'home' goods and services.
4. Suppose that the current Canadian dollar (CAD) to U.S. dollar exchange rate is $.85 CAD = $1
US and that the U.S. dollar price of an Apple iPhone is $300. What is the Canadian dollar price of
an iPhone? Next, suppose that the CAD to US dollar exchange rate moves to $.96 CAD = $1 US.
What is the new Canadian dollar price of an iPhone? Other things equal, would you expect
Canada to import more or fewer iPhones at the new exchange rate? LO3
Answers: $255 CAD; $288; less.
Feedback: Consider the following example. Suppose that the current Canadian dollar
(CAD) to U.S. dollar exchange rate is $.85 CAD = $1 US and that the U.S. dollar price of
an Apple iPhone is $300. What is the Canadian dollar price of an iPhone? Next, suppose
that the CAD to US dollar exchange rate moves to $.96 CAD = $1 US. What is the new
Canadian dollar price of an iPhone? Other things equal, would you expect Canada to
import more or fewer iPhones at the new exchange rate?
The exchange rate is $0.85 Canadian dollars for $1 U.S dollar. As a simple example,
assume a candy bar costs $1 in the U.S. An individual with $0.85 Canadian cents could
use this to purchase a U.S. dollar and buy the candy bar. Thus, the candy bar only costs
$0.85 in Canadian dollars (=0.85 x $1).
We apply the same logic to the iPhone. The iPhone costs $300 U.S. dollars, which
implies it costs $255 Canadian dollars (=0.85 x $300).
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
If the CAD to US dollar exchange rate moves to $.96 CAD = $1 US, the price of the
iPhone increases for Canadians (or individuals with Canadian currency) to $288
Canadian dollars (= 0.96 x $300).
Since the price of the iPhone increases for Canadians (the Canadian currency has
depreciated) they will likely buy fewer (less) iPhones.
5. Return to Problem 3 and assume the exchange rate is fixed against the dollar at the equilibrium
exchange rate that occurs in year 1. Also suppose that Japan and the United States are the only
two countries in the world. In year 2, what quantity of yen would the Japanese government have
to buy or sell to balance its capital and financial account with its current account? In what specific
account would this purchase or sale show up in Japan’s balance of payments statement: Foreign
purchases of assets in Japan or Japanese purchase of assets abroad? Would this transaction
increase Japan’s stock of official reserves or decrease its stock? LO5
Answers: sell 10 billion yen; Japanese purchase of assets abroad; increase.
Feedback: Consider the following example. Return to Problem 3 and assume the
exchange rate is fixed against the dollar at the equilibrium exchange rate that occurs in
year 1. Also suppose that Japan and the United States are the only two countries in the
world. In year 2, what quantity of yen would the Japanese government have to buy or sell
to balance its capital and financial account with its current account? In what specific
account would this purchase or sale show up in Japan’s balance of payments statement:
Foreign purchases of assets in Japan or Japanese purchase of assets abroad? Would this
transaction increase Japan’s stock of official reserves or decrease its stock?
The year 1 equilibrium is 115, where Qd equals Qs (Qd = Qs =20).
In year 2 the quantity of Yen supplied at the exchange rate of 115 is 10 (Qs'=10). To
maintain the fixed exchange rate at 115, there would need to be an increase in the Yen
supply equal to 10 (= 20 (original Qs) - 10 (new Qs')). To accomplish this the Japanese
government would need to sell 10 billion Yen to balance its capital and financial account
with its current account.
This would show up as Japanese purchase of assets abroad in Japan’s balance of
payments statement . The sale of Yen by the Japanese government is the equivalent to
(the same as) a purchase of U.S. dollars (The Japanese purchases U.S. dollars by
supplying more Yen to the currency exchange market). This sale of Yen, or purchase of
U.S. dollars, results in an increase in official reserves.
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Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits
The graph below demonstrates this process. The original equilibrium is 115 with a
quantity of 20. The decrease in supply of Yen at every exchange rate implies the 'Supply
of Yen' schedule shifts to the left. To offset this decline and maintain the fixed exchange
rate of 115 the Japanese government must inject Yen into the market by purchasing U.S.
dollars. This increases Japan's official reserves because they are now holding more U.S.
dollars (U.S. dollars is an asset from abroad , claim against the United States).
Decrease in
Supply of Yen:
Market
New Supply of Yen
Supply of Yen
$/Yen
115
Increase in
Supply of Yen:
Japanese
Government
Demand for Yen
20
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Yen