Chapter 17
Financing World
Trade
Learning Objectives
• Explain how foreign exchange rates are
determined.
• Differentiate between floating and fixed
exchange rate systems.
• Contrast the balance of trade and the
balance of payments.
• Argue why a trade deficit is not necessarily
detrimental to the U.S. economy.
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Trading Currencies in Foreign
Exchange Markets
• The U. S. dollar is the legal currency
accepted in virtually all transactions in this
country.
• Currently there are over 100 different national
currencies in existence.
• When U.S. residents want to purchase goods
or services in other countries, they typically
have to exchange their U.S. dollars for the
other countries’ currencies.
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Trading Currencies in Foreign
Exchange Markets (cont.)
• When foreigners wish to buy goods or invest
in the United States, they have to do the
reverse—exchange their local currency for
U.S. dollars.
• A worldwide market exists for such
exchanges. It is called the foreign exchange
market.
• Like all markets, the worldwide foreign
exchange market responds to the demand
for, and the supply of, different currencies.
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The Demand for Foreign
Exchange—Japanese Yen
• Every time a U.S. resident wants to buy
a Japanese laptop, a Japanese car, or a
Japanese-made MP3 player, such
decisions create a demand for
Japanese yen.
• In this sense, the demand for any
foreign currency is a derived demand,
derived from the demand for the
imported good or service desired.
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17-5
The Demand for Foreign
Exchange—Japanese Yen (cont.)
• The more goods and services U.S.
residents desire to purchase from
Japanese companies, the greater the
demand for Japanese yen. (This
concept applies equally well to all
countries and currencies.)
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17-6
Appreciation and Depreciation
• Let’s say that it costs you 1 cent to purchase
1 yen; that is the exchange rate between
dollars and yen. If tomorrow you had to pay 1
1/4 cents ($0.0125) for the same yen, the
exchange rate would have changed.
• Looking at such a change, we would say that
there has been an appreciation in the value
of the yen, or that there has been a
depreciation in the value of the dollar.
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17-7
The Supply of Foreign Currency
• The more U.S.-made goods and
services Japanese residents desire, the
greater the supply of Japanese yen.
• Japanese residents will be willing to
supply more yen when the dollar price
of yen goes up, because they can then
buy more U.S. goods with the same
quantity of yen.
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17-8
Equilibrium for Each
Foreign Currency
• Equilibrium is a condition in which
there is no further tendency for the price
of something to change, at least in the
short run.
• Equilibrium in the market for a foreign
currency is the result of the worldwide
demand and worldwide supply of that
currency.
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17-9
Equilibrium for Each
Foreign Currency (cont.)
• Figure 17-1, next, shows the equilibrium
price of Japanese yen—the foreign
exchange rate—at a point in time.
• The graph shows the demand for
Japanese yen by U.S. residents and the
supply of Japanese yen offered by
Japanese residents. The result is a
price of 1 cent per yen.
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17-10
Figure 17-1: Finding the Equilibrium Price
of a Foreign Currency
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Shifts in the Demand for Foreign
Currencies
• Assume, for example, that the New York
Times published an article
demonstrating that Japanese laptop
computers were more reliable than
those made in the U.S.
• This would probably cause an increase
in the demand for Japanese laptops.
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17-12
Shifts in the Demand for Foreign
Currencies (cont.)
• Because the demand for Japanese yen
is derived from the demand for
Japanese goods and services, the
result would be a rise in the demand for
yen.
• The price per yen in dollars would then
likely rise.
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17-13
Strong versus Weak Currencies
• Whenever a currency appreciates in
value in the foreign exchange market,
commentators will talk about the
currency strengthening or that it is a
strong currency.
• Whenever a currency depreciates in
value in the foreign exchange market,
commentators refer to it as weakening
or a that it is a weak currency.
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17-14
Shifts in the Demand for
Foreign Currencies
• In Figure 17-2, next, you can see that if U.S.
residents demand more Japanese products,
the derived demand curve for yen will shift
outward to the right from D1 to D2.
• The equilibrium price will rise from 1 cent per
yen to 1.2 cents per yen and the equilibrium
quantity will increase from 3 trillion to 4 trillion
yen per year.
• Equilibrium changes from E1 to E2.
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17-15
Figure 17-2: The Results of a Shift in
the Demand for Japanese Yen
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Shifts in the Supply of Foreign
Currencies
• The supply of Japanese yen can also
change. When that happens, the equilibrium
price of yen is affected.
• For instance, Microsoft Corporation has just
announced a revolutionary operating system
that will make all existing computers run five
times faster. It has announced that this new
operating system will be sold in Japan this
week.
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17-17
Shifts in the Supply of Foreign
Currencies (cont.)
• Consequently, Japanese computer
users will demand more software
products from Microsoft and in the
process supply more yen to the foreign
exchange market.
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17-18
Graphing a Shift in the Supply of
Japanese Yen
• In Figure 17-3, next, you can see that
the supply of Japanese yen has
increased from S to S1. The equilibrium
has changed from point E to E1.
• The equilibrium price of Japanese yen
has dropped in this case from 1 cent per
yen to 0.5 cent per yen, representing a
weakening of the yen in the foreign
exchange market.
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17-19
Figure 17-3: An Increase in the
Supply of Japanese Yen
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What Determines Exchange
Rates?
• There are numerous reasons why the
demand and supply curves for foreign
currencies change.
• Some of the variables that may cause a
change in exchange rates are:
real interest rates, productivity,
consumer preferences, and
perceptions of economic stability
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Floating Exchange Rates
• In a floating (flexible) exchange rate
system, the value of a country’s
currency in terms of other currencies
can change depending on world market
conditions.
• Under a floating exchange rate system,
there is no government intervention to
attempt to keep the exchange rate at a
specific value.
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17-22
Government Intervention in
Foreign Exchange Markets
• Today, most of the world uses a floating
exchange rate system.
• Occasionally, however, governments do
intervene to try to either alter the value
of their own currency in international
exchange markets, or to help some
other country do so.
• The result is called a managed
exchange rate system.
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17-23
Fixing the Exchange Rate
• In much of the world before the 1970s and in
certain countries today, such as China,
exchange rates have been or are fixed by
various governments through intervention in
the foreign exchange market.
• Because of this intervention, there are
virtually no variations in the foreign exchange
value of a domestic currency
in a fixed exchange rate system.
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Foreign Exchange Risk
• The possibility that variations in the market
value of assets can take place because of
changes in the value of a nation’s currency is
called the foreign exchange risk—which
residents of a country face because the value
of their nation’s currency can fluctuate.
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The Balance of Trade
• A currency’s exchange rate can have an
important effect on a nation’s balance of
trade—exports minus imports.
• If a nation’s currency depreciates, the nation
will likely export more goods because its
products will become cheaper for other
nations’ residents to buy.
• At the same time, its residents will tend to
import less because other nations’ goods will
become relatively more expensive.
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Trade in Goods versus
Trade in Services
• When international trade started,
literally thousands of years ago, virtually
all of it was in the form of trade in
goods.
• Today we trade in not only goods, but
also services.
• The United States in a recent year sold
$400 billion of services to other
countries and purchased about $300
billion of services from other countries.
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The Balance of Payments
• The balance of payments is a record
of all the transactions between
households, firms, and the government
of one country with the rest of the world.
• It includes:
– The Current Account Balance, and
– The Capital Account Balance
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Current Account versus Capital
Account Transactions
• Current account transactions involve
trading goods, trading services, and unilateral
transfers.
• Capital account transactions involve
foreign investments, either those made by
foreigners in America, or those made by U.S.
residents in foreign countries.
• Whenever the current account is in deficit, the
capital account is in surplus and vice versa.
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Key Terms and Concepts
• appreciation
• balance of
payments
• balance of trade
• capital account
transactions
• depreciation
• derived demand
• fixed exchange rate
system
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• floating (flexible)
exchange rate
system
• foreign exchange
market
• foreign exchange
risk
• trade deficit
• unilateral transfers
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