ECONOMICS 5e
Michael Parkin
CHAPTER
20
International Finance
Chapter 37 in Economics
Learning Objectives
• Explain how international trade is financed
• Describe a country’s balance of payments
accounts
• Explain what determines the amount of
international borrowing and lending
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-2
Learning Objectives (cont.)
• Explain why the United States changed
from being a lender to being a borrower in
the mid-1980s
• Explain how the foreign exchange value of
the dollar is determined
• Explain why the foreign exchange value of
the dollar fluctuates
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-3
Learning Objectives
• Explain how international trade is financed
• Describe a country’s balance of payments
accounts
• Explain what determines the amount of
international borrowing and lending
We will address all three objectives
simultaneously.
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Slide 20-4
Financing International Trade
Balance of Payments Accounts
Balance of payments accounts record a
country’s international trading, borrowing, and
lending.
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Slide 20-5
Financing International Trade
The balance of payments accounts include:
1) Current account
• Records payments for imports of goods and
service from abroad, receipts from exports of
goods and services sold abroad, net interest
paid abroad, and net transfers (e.g. foreign
aid).
• Current account balance equals exports
minus imports, net interest, and net transfers.
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Slide 20-6
Financing International Trade
The balance of payments accounts include:
2) Capital account
• Records foreign investment in the United
States minus U.S. investment abroad.
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Slide 20-7
Financing International Trade
The balance of payments accounts include:
3) Official settlements account
• Records the change in official U.S. reserves.
• Official U.S reserves are the government’s
holdings of foreign currency.
• If official reserves increase, the official
settlements accounts balance is negative.
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Slide 20-8
U.S. Balance of Payments
Accounts in 1996
Current account
Import of goods and services
Exports of goods and services
Net interest income
Net transfers
Current account balance
-940
+830
–10
–40
–160
Capital account
Foreign investment in the United States
U.S. investment abroad
Statistical discrepancy
Capital account balance
+430
-240
–40
+150
Official settlements account
Decrease in official U.S. reserves
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-10
Slide 20-9
The Balance of Payments:
1975-1998
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Slide 20-10
Financing International Trade
Borrowers and Lenders, Debtors and
Creditors
• A net borrower is a country that is borrowing
more from the rest of the world than it is
lending.
• A net lender is a country that is lending more
than it is borrowing.
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Slide 20-11
Financing International Trade
Borrowers and Lenders, Debtors and
Creditors
• Debtor nations are countries that during their
entire history have borrowed more from the rest
of the world than they have lent to it.
• Creditor nations are countries that have
invested more in the rest of the world than other
countries have invested in it.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-12
Learning Objectives (cont.)
• Explain why the United States changed
from being a lender to being a borrower in
the mid-1980s
• Explain how the foreign exchange value of
the dollar is determined
• Explain why the foreign exchange value of
the dollar fluctuates
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-13
Financing International Trade
Borrowers and Lenders, Debtors and
Creditors
• The United States is both a net borrower and a
debtor nation.
• We became a borrower as a result of a string of
current account deficits.
Is there any reason to be concerned?
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Slide 20-14
Financing International Trade
No — if the borrowing is financing
investment that is generating economic
growth and higher income.
Yes — if the money is being used to finance
consumption.
This will result in higher interest payments and
consumption will eventually have to be
reduced.
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Slide 20-15
Financing International Trade
Current Account Balance
The current account balance (CAB) equals:
CAB  NX  Net interest income  Net transfers
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Slide 20-16
Financing International Trade
Net Exports
• Net exports have the largest impact on the
current account balance.
• They are determined by the government budget
and private saving and investment.
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Slide 20-17
Financing International Trade
Net Exports
• Net exports is exports of goods and services
minus imports of goods and services.
• A government sector surplus or deficit is net
taxes minus government purchases of goods
and services.
• A private sector surplus or deficit is saving
minus investment.
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Slide 20-18
Net Exports, the Government
Budget, Saving, and Investment
United States
Symbols and
in 1996
equations (billions of dollars)
Variables
Exports
X
855
Imports
M
954
Government
purchases
G 1,407
Net Taxes
T
1,340
Investment
I
1,116
Saving
S
1,084
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-19
Net Exports, the Government
Budget, Saving, and Investment
Surpluses and deficits
Net Exports
X - M 855 – 954 = -99
Government sector
T - G 1,340 – 1,407 = –67
Private sector
S - I 1,084 – 1,116 = –32
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Slide 20-20
Net Exports, the Government
Budget, Saving, and Investment
Relationship among surpluses and deficits
National accounts
Y =C+I+G+X–M
=C+S+T
Rearranging
X –M=S–I+T–G
Net exports
X–M
–99
T –G
–67
S –I
–32
equals:
Government sector
plus
Private sector
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Slide 20-21
Financing International Trade
The Twin Deficits
Since there is a tendency for the government
sector deficit and the net exports deficit to
move in the same direction, they are sometimes
referred to as the twin deficits.
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Slide 20-22
The Twin Deficits
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Slide 20-23
Financing International Trade
Is U.S. Borrowing for Consumption or
Investment
• Net exports were –$99 billion in 1996
• The government buys structures (e.g. highways,
dams) that exceed $200 billion/year.
• The government spends on education and
health care—increases human capital.
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Slide 20-24
Financing International Trade
Is U.S. Borrowing for Consumption or
Investment
Our borrowing is financing investment
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Slide 20-25
Learning Objectives (cont.)
• Explain why the United States changed
from being a lender to being a borrower in
the mid-1980s
• Explain how the foreign exchange value of
the dollar is determined
• Explain why the foreign exchange value of
the dollar fluctuates
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-26
The Exchange Rate
• The foreign exchange market is the market
in which the currency of one country is
exchanged for the currency of another.
• The foreign exchange rate is the price at
which one currency exchanges for another.
• In April 1997==>$1 = 123 Japanese yen
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Slide 20-27
The Exchange Rate
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Slide 20-28
The Exchange Rate
Currency depreciation is the fall in the value
of one currency in terms of another.
• The dollar depreciates if in later months it will
buy less yen than before (e.g. 90 yen as
compared to 114).
Currency appreciation is the rise in the value
of one currency in terms of another
currency.
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Slide 20-29
The Exchange Rate
Demand in the Foreign Exchange Market
The quantity of dollars demanded in the foreign
exchange market depends upon:
1) The exchange rate
2) Interest rates in the United States and other
countries
3) The expected future exchange rate
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Slide 20-30
The Exchange Rate
The Law of Demand for Foreign Exchange
• The demand for dollars is aderived
demand.
• They buy dollars in order to buy U.S.-made
goods and services.
• Holding other things the same, the higher the
exchange rate, the less is the quantity of dollars
demanded.
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Slide 20-31
Exchange rate (yen per dollar)
The Demand for Dollars
Other things remaining
the same, a rise in the
exchange rate decreases
the quantity of dollars
demanded...
150
100
50
0
…and a fall in the
exchange rate
increases the quantity
of dollars demanded
1.1
1.2
1.3
D
1.4
1.5
Quantity (trillions of dollars per day)
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Slide 20-32
The Exchange Rate
Why do exchange rates influence the
quantity of dollars demanded?
1) Exports Effect
2) Expected Profit Effect
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Slide 20-33
The Exchange Rate
Changes in the Demand for Dollars
A change in any other influence on the dollars
that people plan to buy in the foreign exchange
market:
• Changes the demand for dollars
• Shifts the demand curve for dollars
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Slide 20-34
The Exchange Rate
The other factors that change the demand
for dollars are:
1) Interest rates in the United States and
other countries
2) The expected future exchange rate
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Slide 20-35
Exchange rate (yen per dollar)
Changes in the Demand for Dollars
150
Increase in the
demand for dollars
100
50
Decrease
in the
demand for
dollars
D2
0
1.1
1.2
1.3
1.4
D0
D1
1.5
Quantity (trillions of dollars per day)
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Slide 20-36
Changes in the
Demand for Dollars
The demand for dollars
increases if:
The demand for dollars
decreases if:
• The U.S interest rate
• The U.S. interest rate
differential increases
differential decreases
• The expected future
• The expected future
exchange rate rises
exchange rate falls
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Slide 20-37
The Exchange Rate
Supply in the Foreign Exchange Market
The quantity of dollars supplied in the foreign
exchange market depends upon:
1) The exchange rate
2) Interest rates in the United States and
other countries
3) The expected future exchange rate
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Slide 20-38
The Exchange Rate
The Law of Demand for Foreign Exchange
• People supply dollars in the foreign exchange
market when they buy U.S. imports.
• Holding other things the same, the higher the
exchange rate, the higher is the quantity of
dollars supplied.
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Slide 20-39
The Exchange Rate
Why do exchange rates influence the
quantity of dollars supplied?
1) Imports Effect
2) Expected Profit Effect
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Slide 20-40
Exchange rate (yen per dollar)
The Supply of Dollars
150
Other things remaining
the same, a rise in the
exchange rate increases
the quantity of dollars
supplied...
S
100
…and a fall in the
exchange rate
decreases the quantity
of dollars supplied
50
0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-41
The Exchange Rate
Changes in the Supply of Dollars
A change in any other influence on the dollars
that people plan to sell in the foreign exchange
market:
• Changes the supply of dollars
• Shifts the supply curve of dollars
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Slide 20-42
The Exchange Rate
The other factors that change the supply of
dollars are:
1) Interest rates in the United States and
other countries
2) The expected future exchange rate
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Slide 20-43
The Supply of Dollars
Exchange rate (yen per dollar)
S1
150
S0
Decrease in the
supply of dollars
S2
100
Increase in the
supply of dollars
50
0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-44
Changes in the
Supply of Dollars
The supply of dollars
increases if:
The demand for dollars
decreases if:
• The U.S interest rate
• The U.S. interest rate
differential decreases
differential increases
• The expected future
• The expected future
exchange rate falls
exchange rate rises
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Slide 20-45
The Exchange Rate
Market Equilibrium
• If the exchange rate is too high, there is a
surplus of dollars.
• If the exchange rate is too low, there is a
shortage of dollars.
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Slide 20-46
The Exchange Rate
Market Equilibrium
At the equilibrium exchange rate, there is
neither a shortage nor a surplus.
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Slide 20-47
Exchange rate (yen per dollar)
Equilibrium Exchange Rate
Surplus at
150 yen per dollar
S
150
Equilibrium at
100 yen per dollar
100
50
D
Shortage at
50 yen per dollar
0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-48
Learning Objectives (cont.)
• Explain why the United States changed
from being a lender to being a borrower in
the mid-1980s
• Explain how the foreign exchange value of
the dollar is determined
• Explain why the foreign exchange value of
the dollar fluctuates
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 20-49
The Exchange Rate
Changes in the Exchange Rate
Why the Exchange Rate is Volatile
• Supply and demand are not independent of
each other.
• A change in the expected future changes or
U.S. interest rate differential changes both
supply and demand.
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Slide 20-50
Exchange rate (yen per dollar)
Exchange Rate Fluctuations
1994 to 1995
S94
S95
100
84
D94
D95
0
Q0
Quantity (trillions of dollars per day)
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Slide 20-51
Exchange rate (yen per dollar)
Exchange Rate Fluctuations
1995 to 1997
S97
S95
123
D97
84
D95
0
Q0
Quantity (trillions of dollars per day)
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Slide 20-52
The Exchange Rate
Exchange Rate Expectations
Two expectations that effect the value of money
are:
1) Purchasing power parity
2) Interest rate parity
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Slide 20-53
The Exchange Rate
Purchasing Power Parity
• Money is worth what it will buy.
• Purchasing power parity means equal value of
money.
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Slide 20-54
The Exchange Rate
Purchasing Power Parity
• If prices increase in Canada (for example) and
other countries but remain constant in the
United States, people will generally expect that
the value of the U.S. dollar is too low and will
expect it to rise.
• Supply of and demand for dollars change
• The exchange rate changes
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Slide 20-55
The Exchange Rate
Interest Rate Parity
• Money is worth what it can earn.
• Interest rate parity means equal interest rates.
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Slide 20-56
The Exchange Rate
Interest Rate Parity
If the rate of return on the dollar is higher in the
United States than another, the demand for U.S.
dollars rise and the exchange rate rises until
expected interest rates are equal.
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Slide 20-57
The Exchange Rate
The Fed in the Foreign Exchange Market
• Since the Fed influences the supply of money, it
also has an impact on the exchange rate.
• The Fed can intervene in the foreign exchange
market and smooth out fluctuations in the
exchange rate.
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Slide 20-58
Exchange rate (yen per dollar)
Foreign Exchange
Market Intervention
S
130
Target exchange
rate
130
120
130
130
D2
0
1.1
1.2
1.3
1.4
D0
D1
1.5
Quantity (trillions of dollars per day)
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Slide 20-59
The End
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Slide 20-60