International Finance
The Balance of Payments
• Balance of Payments: a periodic statement
(usually annual) of the money value of all
transaction between residents of one country
and residents of all other countries.
Debit and Credit
• Any transaction that supplies the country’s
currency in the foreign exchange market is
recorded as a debit (-).
• Any transaction that creates a demand for the
country’s currency in the foreign exchange
market is recorded as a credit (+).
Current Account
• Current Account includes all payments related to
the purchase and sale of goods and services.
Includes the following:
• Exports of Goods and Services: includes
investment income, goods, and services –
increases demand for U.S. dollars and supply of
foreign currency. Recorded as a credit.
• Imports of Goods and Services: includes
goods, services, and income on foreign owned
assets – increases demand for foreign
currencies and supply of U.S. dollars. Recorded
as a debit.
Current Account (part 2)
• Net Unilateral Trade Abroad: one-way money
payments. Go from Americans or U.S.
Government to foreigners or foreign governments.
• Merchandise Trade Balance: The difference
between the value of merchandise exports and the
value of merchandise imports.
• Merchandise Trade Deficit: The situation where
the value of merchandise exports is less than the
value of merchandise imports.
• Merchandise Trade Surplus: The situation where
the value of merchandise exports is greater than
the value of merchandise imports.
Capital Account
Capital Account includes all payments related to
the purchase and sale of assets and to
borrowing and lending activities.
• Outflow of U.S. Capital: American purchases of
foreign assets and U.S. loans to foreigners are
outflows of U.S. Capital
• Inflow of Foreign Capital: Foreign purchases of
U.S. assets and foreign loans to Americans are
inflows of foreign capital.
The Capital Account Balance is the summary
statistic for these two items.
Account and Discrepancy
• Official Reserve Account: A government possesses
official reserve balances in the form of foreign
currencies, gold, its reserve position in the
International Monetary Fund, and Special Drawing
Rights. An increase in official reserves is like an
outflow of capital in the capital account and
appears as a payment with a negative sign.
• Statistical Discrepancy: Balance of Payment
accountants do not have complete information;
they can only record credits and debits they
observe. They use the statistical discrepancy
which is part of the balance of payments that
adjusts for missing information.
Alternate Balance of Payments
Equals
•
•
•
•
Current account balance
Capital account balance
Official reserve balance
Statistical discrepancy.
Q&A
• If an American retailer buys Japanese cars from
a Japanese manufacturer, is this transaction
recorded as a debit or a credit? Explain your
answer.
• Exports of goods and services equal $200 billion
and imports of goods and services equal $300
billion. What is the merchandise trade balance?
• What is the difference between the merchandise
trade balance and the current account balance?
Flexible Exchange Rates
• Exchange Rate is the price of one currency in
terms of another currency.
• Flexible Exchange Rate System: The system
whereby exchange rates are determined by the
forces of supply and demand for a currency.
The Demand for Goods and
the Supply of Currencies
The Foreign Exchange Market
The Foreign Exchange Market
Comments on the graph:
The demand for pounds is downward sloping. The higher
the dollar price for pounds, the fewer pounds will be
demanded; the lower the dollar price for pounds, the more
pounds that will be demanded. At $1.90 = £1, there is a
surplus of pounds, placing downward pressure on the
exchange rate. At $1.10 = £ 1, there is a shortage of
pounds, placing upward pressure on the exchange rate. At
the equilibrium exchange rate, $1.50 = £ 1, the quantity
demanded of pounds equals the quantity supplied of
pounds.
Changes in the Equilibrium Rate
A change in the demand or supply of a currency (or
both) will change the equilibrium dollar price for
that currency. The following can change the
Equilibrium Rate:
– A Difference in Income Growth Rates
– Difference in Relative Inflation Rates
– Changes in Real Interest Rates
The Purchasing Power Parity
Theory
In the long run, changes in the relative price
levels of two countries will affect the exchange
rate in such a way that one unit of a country’s
currency will continue to buy the same amount
of the foreign goods as it did before the
change in relative price levels.
Fixed Exchange Rates
• A Fixed Exchange Rate System is the system
where a nation’s currency is set at a fixed rate
relative to all other currencies, and central
banks intervene in the foreign exchange
market to maintain the fixed rate.
• Overvaluation occurs when a currency’s
current price, in terms of other currencies, is
above the equilibrium price.
• Undervaluation occurs when a currency’s
current price, in terms of other currencies, is
below the equilibrium price.
A Fixed Exchange Rate System
A Fixed Exchange Rate
System
Comments on the graph:
In a fixed exchange rate system, the exchange rate
is fixed – and it may not be fixed at the equilibrium
exchange rate. The graph shows two cases. (1) If
the exchange rate is fixed at price 1, the pound is
overvalued, the dollar is undervalued, and a
surplus of pounds exist. (2) If the exchange rate is
fixed at official price 2, the dollar is overvalued, and
a shortage of pounds exist.
What’s so Bad About An
Overvalued Dollar?
• The exchange rate affects the amount of U.S.
exports and imports – this then affects the
merchandise trade balance.
• As U.S. exports become more expensive for
other countries, they buy fewer U.S. exports. If
the exports fall below imports, the U.S. is in a
trade deficit.
Fixed Exchange Rates and an
Overvalued Dollar
Fixed Exchange Rates and an
Overvalued Dollar
Comments on the graph:
Initially, the demand for and supply of pounds are
represented by D1 and S1, respectively. The equilibrium
exchange rate is $1.50 = £1, which also happens to be the
official (fixed) exchange rate. In time, the demand for
pounds rises to D2, and the equilibrium exchange rate rises
to $2 = £1. Since the official exchange rate is fixed, the
dollar will be overvalued, which could lead to a trade deficit.
Government Involvement in a
Flexible Exchange System
Suppose there is a surplus of pounds.
• The Fed might buy the pounds with dollars,
causing the demand for pounds to increase and
the demand curve for pounds to shift to the right.
This would raise the equilibrium rate.
• The Bank of England might buy the pounds with
its reserve dollars, increasing the demand for
pounds and the equilibrium rate.
• Or, the Fed and the Bank of England might both
buy the pounds.
Options Under a Fixed
Exchange Rate System
Suppose there is a surplus of pounds that has lasted
several weeks. What might happen?
• Devaluation and Revaluation: Great Britain and the U.S.
could agree to reset the official price of the pound and the
dollar.
– Devaluation occurs when the official price of a currency is lowered.
– Revaluation occurs when the official price of a currency is raised.
Options Under a Fixed
Exchange Rate System
Suppose there is a surplus of pounds that has lasted
several weeks. What might happen?
• Protectionist Trade Policy: A drop in the domestic
consumption of foreign goods goes hand in hand with a
decrease in the demand for foreign currencies.
• Changes in Monetary Policy: The U.S. might enact a tight
monetary policy to retard inflation and drive up interest rates
(in the short run). The tight monetary policy will reduce the
U.S. rate of inflation and thereby lower U.S. prices relative to
prices in other nations.
Fixed Exchange Rates Vs.
Flexible Exchange Rates
• Fixed Exchange Rates provide certainty in
price & exchange, which promotes
international trade. On the other hand,
flexible exchange rates stifle International
trade.
• Flexible Exchange Rates allow a country to
adopt policies to meet domestic economic
goals, instead of sacrificing domestic
economic goals to maintain an exchange
rate.
Fixed Exchange Rates Vs.
Flexible Exchange Rates
• There is also a great chance the Fixed
Exchange Rate will diverge greatly with the
equilibrium exchange rate, creating persistent
balance of trade problems.
Optimal Currency Areas
Optimal Currency Area is a geographic are
in which exchange rates can be fixed or a
common currency used without sacrificing
domestic economic goals, such as low
unemployment.
Costs, Benefits, and Optimal
Currency Areas
• The costs include the cost of exchanging one
currency for another and the added risk of not
knowing the value of one’s currency will be on
the foreign market.
• When labor in countries within a certain
geographic area is mobile enough to move
easily and quickly in response to changes in
relative demand, the countries are said to
constitute an optimal currency area.
The Current International
Monetary System
• Referred to as a Managed Float: a
managed flexible exchange rate system,
under which nations now and then
intervene to adjust their official reserve
holdings to moderate major swings in
exchange rates.
• Like everything else, the current system
has proponents and opponents.
Proponents of the Managed
Float System Say:
• It allows nations to pursue independent
monetary policies.
• It solves trade problems without trade
restrictions (trade imbalances are usually
solved through changes in exchange
rates).
• It is flexible and therefore can easily adjust
to shocks.
Opponents of the Managed
Float System Say:
• It promotes exchange rate volatility and
uncertainty and results in less international trade
than would be the case under fixed exchange
rates.
• It promotes inflation.
• Changes in exchange rates alter trade balances
in the desired direction only after a long time, in
the short run, a depreciation in a currency can
make the situation worse instead of better.