INTRODUCTION TO ECONOMICS
Dominika Milczarek-Andrzejewska
Lecture 12
Exchange Rates,
the Balance of Payments,
and Trade Deficits
Outline
1. Financing International Trade
2. The Balance of Payments
3. Flexible Exchange Rates
4. Fixed Exchange Rates
5. International Exchange Rate Systems
2
1
Foreign Exchange Markets
• enable international transactions to
take place by providing markets for the
exchange of national currencies
3
Export and Import Transactions
• Example:
– A U.S. firm is selling $300,000 worth of
computers to a British firm
– A U.S. firm is buying 150,000 pounds
worth of compact discs from Britain
4
2
Export and Import Transactions
Example:
– Exports create a demand for dollars and a
supply of foreign money (British pounds)
• The financing of an American export reduces
the supply of money in Britain and increases it
in the U.S.
– Imports create a demand for foreign
currency (pounds) and a supply of U.S.
currency
• The financing of American imports reduces the
supply of money in the U.S. and increases it in
the exporting country (Britain)
5
Balance of Payments
• is the sum of all transactions that take place
between its residents and the residents of all
foreign nations
– merchandise exports and imports,
– tourist expenditures,
– and interest plus dividends from the sale and
purchases of financial assets abroad
• Three components
– the current account,
– the capital account,
– and the official reserves account
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3
Chapter 38
Table 38.1
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Current Accounts
1. summarizes trade in currently
produced goods and services
2. the merchandise trade balance is the
difference between exports and
imports of goods
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4
U.S. Trade Balances in Goods,
Selected Nations, 2001
-80
-70
-60
-50
-40
-30
-20
-10
0
10
20
Australia
Belgium
Canada
China
Germany
Japan
Mexico
Netherlands
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Capital Account
• summarizes the flows of payments from the
purchase or sale of real or financial assets
• for example:
– a foreign firm buys a real asset or a U.S.
government bond
– “export” of the ownership of U.S. assets from the
United States in return for payments of foreign
currency
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5
Official Reserves Account
• quantities of foreign currencies hold by the
central banks of nations
• can be drawn on to make up any net deficit
in the combined current and capital
accounts
– a drawing down of official reserves measures a
nation’s balance of payments deficit
• shown as a + in the Official reserves account
– adding to foreign reserves would occur if there is
a surplus
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Payments Deficits and Surpluses
• A balance of payments deficit is not
necessarily bad
• However, persistent payments deficits would
deplete the foreign exchange reserves
• To correct its balance of payments deficit, a
nation might:
– implement a major depreciation of its currency
– or other policies to encourage exports
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6
Flexible Exchange Rates
• Freely floating exchange rates are
determined by the forces of demand
and supply
– downsloping demand curve
– upsloping supply curve
– price or exchange rate
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THE MARKET FOR CURRENCY
Dollar price of one pound
P
EXCHANGE
RATE: $2 = £1
S
3
2
Dollar
depreciates
Dollar
appreciates
1
D
Quantity of pounds
Q
14
7
Flexible Exchange Rates
• Depreciation
– value of a currency is falling
– it takes more units of that country’s
currency to buy another country’s
currency.
• $3 for 1 pound is a depreciation of the dollar
(compared to example of $2 per pound)
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Flexible Exchange Rates
• Appreciation
– value of a currency or its purchasing
power is rising
– it takes less of that currency to buy
another country’s currency
• $1 = 1 pound is an appreciation of the dollar
relative to the pound
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8
Flexible Exchange Rates
Determinants of exchange rates:
1. Changes in tastes or preferences for a country’s
products
2. Relative income changes
3. Relative price changes
4. Changes in relative real interest rates
5. Speculation
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Flexible Exchange Rates
• automatically correcting any imbalance in
the balance of payments
– a deficit in the balance of payments => a surplus
of that currency and its value depreciates
– as depreciation occurs => demand for goods and
services from that country rises and the imports
become more costly
– with rising exports and falling imports, the
deficit is eventually corrected
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9
Flexible Exchange Rates
• Disadvantages to flexible exchange
rates:
– Uncertainty and diminished trade
– Terms of trade may be worsened
– Unstable exchange rates can destabilize a
nation’s economy
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Fixed Exchange Rates
• are pegged to some set value, such as gold or the
U.S. dollar
• Official reserves are used to correct an imbalance in
the balance of payments,
– since exchange rates cannot fluctuate to bring about
automatic balance
– currency intervention
• to avoid imbalance in trade and payments:
– trade policies directly controlling the amount of trade and
finance
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10
Fixed Exchange Rates
•
Effects of exchange controls and the
rationing of currency:
1. Controls distort efficient patterns of trade
2. Rationing involves favoritism among importers
3. Rationing reduces freedom of consumer choice
4. Enforcement problems are likely as “black
market” rates develop
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International
Exchange Rate Systems
• Gold standard system
• Bretton Woods system
• Current system – „managed float”
• The gold standard system
– In the 1879-1934 period
– It provided for fixed exchange rates in terms of a certain
amount of currency for an ounce of gold
– Maintaining a fixed relationship between the stock of gold
and the money supply
– Gold flows would maintain the fixed rate
• For example: if the dollar appreciated, gold would flow into
the U.S.
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11
International
Exchange Rate Systems
• enacted following World War II by the
leading industrialized Western nations
• Main features:
– International Monetary Fund (IMF) was created to
hold and lend official reserves
– Pegged exchange rates
• adjustable when a fundamental imbalance was
recognized
• maintained by government intervention in the supply
and demand of currencies
• could be changed when there were persistent problems
with the balance of payments
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International
Exchange Rate Systems
• The current system - “managed float”
exchange rate system
– governments attempt to prevent rates from
changing too rapidly in the short term
– the G8 nations (U.S., Germany, Japan, Britain,
France, Italy, Canada and Russia) meet regularly
to assess economic conditions and coordinate
economic policy
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12
International
Exchange Rate Systems
• In support of the managed float:
– Trade has expanded and not diminished under
this system
– Flexible rates have allowed international
adjustments to take place
• Concerns with the managed float:
– Much volatility occurs without the balance of
payments adjustments predicted
– too unpredictable
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Key Terms
• balance of payments
• current account
• balance on goods &
services
• trade deficit
• trade surplus
• balance on current
account
• capital account
• balance on capital
account
• official reserves
• balance of payment
deficits & surpluses
• flexible-or-floatingexchange-rate system
• fixed exchange-rate
system
• purchasing-power-parity
theory
• currency interventions
• exchange controls
• gold standard
• devaluation
• Bretton Woods system
• International Monetary
Fund (IMF)
• managed floating
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exchange rates
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