Ch. 32: International
Finance
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
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The Balance of Payments


Balance of Payments: a periodic statement
(usually annual) of the money value of all
transactions between residents of one country and
residents of all other countries.
Provides information about a nation’s:
– imports and exports
– domestic residents’ earnings on assets located
abroad
– foreign earnings on domestic assets
– gifts to and from foreign countries (including foreign
aid)
– official transactions by governments and central
banks.
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The Balance of Payments



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Debit: any transaction that supplies the country’s
currency in the foreign exchange market.
Foreign Exchange Market: the market in which
currencies of different countries are exchanged.
Credit: any transaction that creates a demand for
the country’s currency in the foreign exchange
market.
Current Account: includes all payments related
to the purchase and sale of goods and services.
Components include: exports, imports, and net
unilateral transfers abroad.
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Exhibit 1: Debits and Credits
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Exhibit 2: U.S. Balance of Payments,
Year Z
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Exhibit 2: U.S. Balance of Payments,
Year Z
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Current Account
Current Account: includes all payments


related to the purchase and sale of goods
and services. Includes:
Exports of Goods and Services: exports
of goods, exports of services, and income
from assets owned abroad. Recorded as
credits (+).
Imports of Goods and Services: imports
of goods, imports of services, and income
from foreign owned domestic assets.
Recorded as a debit (-).
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Current Account
Net Unilateral Transfers Abroad: Net
one-way money payments.
 From Americans or U.S. Government to
foreigners or foreign governments (-).
or
 From foreigners or foreign
governments to Americans or the U.S.
Government (+).
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Current Account



Merchandise Trade Balance: the
difference between the value of
merchandise exports and imports.
Merchandise Trade Deficit: amount
that merchandise exports is less than
merchandise imports.
Merchandise Trade Surplus:
amount that merchandise exports is
greater than merchandise imports
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Exhibit 3: U.S. Merchandise
Trade Balance
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Capital Account
Capital Account: 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.
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Official Reserve Account and
Statistical Discrepancy
Official Reserve Account: official
reserve balances in the form of
foreign currencies, gold, its reserve
position in the International Monetary
Fund, and Special Drawing Rights.
 Statistical Discrepancy:
adjustment to the balance of
payments due to incomplete or
inaccurate information.

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What the Balance Of
Payments Equals

Current Account Balance
– Exports of goods and services
– Imports of goods and services
– Net unilateral transfers

Capital Account Balance
– Outflow of U.S. capital
– Inflow of foreign capital

Official Reserve Balance
– Increase in U.S. official reserve assets
– Increase in foreign official assets in the U.S.

Statistical Discrepancy
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Self-Test



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?
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Flexible Exchange Rates


Exchange Rate: the
price of one currency
in terms of another
currency.
Flexible Exchange
Rate System: A
system whereby
exchange rates are
determined by the
forces of supply and
demand for a currency.
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The Demand For Goods
and Currencies


Country A’s demand for Country B’s
goods leads to a demand for B’s
currency and a supply of A’s currency
on the foreign exchange market.
B’s demand for A’s goods leads to a
demand for A’s currency and a supply
of B’s currency on the foreign
exchange market.
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Exhibit 4: The Demand for Goods and
the Supply of Currencies
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Exhibit 5: Translating U.S. Demand for Pesos into
U.S. Supply of Dollars and Mexican Demand
for Dollars into Mexican Supply of Pesos
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Exhibit 6: A Flexible Exchange
Rate System
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Changes in the Equilibrium
Rate

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Difference in Income Growth Rates
– Higher Relative Growth = Weaker Currency
– Lower Relative Growth = Stronger Currency
Difference in Relative Inflation Rates
– Higher Relative Inflation = Weaker Currency
– Lower Relative Inflation = Stronger Currency
Changes in Real Interest Rates
– Higher Relative Real Interest Rates = Stronger
Currency
– Lower Relative Interest Rates = Weaker
Currency
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Exhibit 7: The Growth Rate of Income
and the Exchange Rate (US
Growth Higher)
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Exhibit 8: Inflation, Exchange Rates,
and Purchasing Power Parity
(PPP) Higher US Inflation
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Purchasing Power Parity
Theory
Purchasing Power
Parity Theory: the
exchange rates
between any two
currencies will
adjust to reflect
changes in the
relative price levels
of the two countries.
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Self-Test




In the foreign exchange market, how is the
demand for dollars linked to the supply of pesos?
What could cause the U.S. dollar to appreciate
against the Mexican peso on the foreign
exchange market?
Suppose the U.S. economy grows while the
Swiss economy does not. How will this affect
the exchange rate between the dollar and the
Swiss franc? Why?
What does the Purchasing Power Parity Theory
say? Give an example to illustrate your answer.
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Fixed Exchange Rates



Fixed Exchange Rate System: 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: when a currency’s current
price, in terms of other currencies, is above the
equilibrium price.
Undervaluation: when a currency’s current
price, in terms of other currencies, is below the
equilibrium price.
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Exhibit 9: A Fixed Exchange Rate
System
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Exhibit 10: Fixed Exchange Rates
and an Overvalued Dollar
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What’s so Bad About An
Overvalued Dollar?
As U.S. exports
become more
expensive for other
countries, they buy
fewer U.S. exports.
If exports fall below
imports, the U.S. is
in a trade deficit.
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Government Involvement in
a Fixed Exchange System
Suppose there is a surplus of pesos.
 The Fed might buy pesos with dollars,
causing the demand for pesos will increase
and its demand curve will shift to the right.
 The Banco de Mexico might buy the peso
with its reserve dollars, increasing the
demand for pesos and the equilibrium rate.
 Or, the Fed and the Banco de Mexico might
both buy pesos.
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Options Under a Fixed
Exchange Rate System

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
Devaluation and Revaluation
– Devaluation occurs when the official
price of a currency is lowered.
– Revaluation occurs when the official
price of a currency is raised.
Protectionist Trade Policy
Changes in Monetary Policy
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The Gold Standard
Fixed Exchange Rate System
To have a gold standard,
countries must:
 Define their currencies in
terms of gold.
 Stand ready and willing
to convert gold into
paper money and paper
money into gold.
 Link their money supplies
to their holdings of gold.
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Economists and The Gold
Standard


Some economists argue “The gold
system subjects domestic monetary
policy to international instead of
domestic considerations.”
Some economists argue the same
thing about the fixed exchange rate
system.
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Self-Test


Under a fixed exchange rate system, if
one currency is overvalued then
another currency must be
undervalued. Explain why this is true.
How does an overvalued dollar affect
U.S. exports and imports?
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Self-Test

In each case, identify whether the U.S.
dollar is overvalued or undervalued:
– The fixed exchange rate is 2 dollars = 1 pound and
the equilibrium exchange rate is 3 dollars = 1 pound.
– The fixed exchange rate is 1.25 dollars = 1 euro and
the equilibrium exchange rate is 1.10 dollars = 1
euro.
– The fixed exchange rate is 1 dollars = 10 pesos and
the equilibrium exchange rate is 1 dollars = 14
pesos.

Under a fixed exchange rate system, why
might the United States want to devalue its
own currency?
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Fixed Exchange Rates Versus
Flexible Exchange Rates


Fixed Exchange Rates provide
certainty, and that certainty of price &
exchange promotes international trade.
Persistent balance of trade problems
could develop.
Flexible Exchange Rates allow a
country to adopt policies to meet
domestic economic goals. But, flexible
exchange rates can dampen
international trade.
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Optimal Currency Areas
Optimal Currency
Area: a geographic
area in which
exchange rates can
be fixed or a
common currency
used without
sacrificing domestic
economic goals.
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Optimal Currency Areas
Assume : Demand for Canadian goods is falling as
demand for U.S. goods are rising:
 Trade and Labor Mobility: if labor is mobile, then
changes in relative demand pose no major economic
problems for either country.
 Trade and Labor Immobility: The results depend
on whether the Exchange Rates are fixed of flexible:
– If exchange rates are flexible, the value of U.S.
currency changes vis-à-vis Canadian currency.
– If exchange rates are fixed, U.S. goods will not
become relatively more expensive for Canadians
and Canadian goods will not become relatively less
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expensive for Americans..
Costs, Benefits, and
Optimal Currency Areas


Costs of flexible exchange rates include the
cost of exchanging one currency for another
and the added risk of not knowing the value
of what 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.
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The Current International
Monetary System

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.
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Proponents of the Managed
Float System Say:
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

It allows nations to pursue
independent monetary policies.
It solves trade problems without trade
restrictions.
It is flexible and therefore can easily
adjust to shocks.
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Opponents of the Managed
Float System Say:
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

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.
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Self-Test

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
What is an optimal currency area? Give an
example.
Country 1 produces good X and Country 2 produces
good Y. People in both countries begin to demand
more of good X and less of good Y. Assume there
is no labor mobility between the two countries and
that a flexible exchange rate system exists. What
will happen to the unemployment rate in country 2?
Explain your answer.
How important is labor mobility in determining
whether or not an area is an optimal currency area?
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The End
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