International Trade and Foreign Exchange Markets
I. The Balance of Payments – The sum of all the transactions
that take place between a country and foreign countries. For
our purposes, they are recorded in two accounts:
A. The Current Account - the sum of a country’s
exports (+) and imports (-).
1. Goods
2. Services
3. Investment income
4. Net transfers.
International Trade and Foreign Exchange Markets
B. The Financial Account (used to be Capital Account)
– Purchase or sale of assets from and to foreigners.
1. Foreigners buy U.S. assets (+)
2. U.S. citizen buys foreign assets (-)
3. Real assets
a. Factories
b. Office buildings
c. etc.
4. Financial assets
a. Government bonds
b. Corporate bonds
c. Stocks
d. etc.
International Trade and Foreign Exchange Markets
C. The current account and the financial account must
always balance.
1. There is some discrepancy about this.
Different textbooks say different things.
2. Your textbook includes a separate “official
reserves account,” but this seems to have disappeared in
recent texts and on the AP exam. It has become part of the
financial account (which your book calls the capital account).
3. Suffice it to say: Any credit in the current
account must be matched by a debit in the financial account
and vice versa.
International Trade and Foreign Exchange Markets
Problem Set #1:
Which of these is a current account transaction?
(A) India buys $10 billion of new U.S. treasury bonds.
(B) A U.S. firm buys 5% of the stock of another US.
Firm.
(C) A U.S. firm builds a new factory in Kenya.
(D) A U.S. firm sells $500 million worth of candles to
an Australian importer.
(E) The U.S. buys $8 billion worth of euros.
International Trade and Foreign Exchange Markets
Problem Set #2:
(a) What does it mean to say that a country has a current
account deficit?
(b) If a country does have a current account deficit, what
must be true of its financial account (née capital
account)?
International Trade and Foreign Exchange Markets
II. Foreign Currency exchange rates and the foreign currency
market.
A. To buy imports, you need the currency of the
country your importing from. For example, when Best Buy
imports Korean televisions, it needs won, not dollars.
B. To do so, Best Buy would buy Korean won on the
foreign exchange market (from a bank or currency dealer).
C. Foreign exchange rates are flexible, meaning the
value of one currency against another can fluctuate.
D. The price of a foreign currency is set by supply and
demand in the foreign exchange market, just like anything
else.
http://www.xe.com/currencycharts/?from=KRW}&to=
USD&view=1Y
International Trade and Foreign Exchange Markets
E. So what determines the value of one currency
versus another? Supply and demand. If demand for a nation’s
currency increases, the currency will appreciate. If demand
decreases, the currency will depreciate.
appreciate – When a currency goes up in value.
depreciate – When a currency goes down in value.
Flexible Exchange Rates
The Market for Foreign Currency
(Pounds)
P
Dollar Price of 1 Pound
(Dollar/Euro)
S1
$3
$2
Dollar
Depreciates
(Pound
Appreciates)
Exchange
Rate: $2 = £1
Dollar
Appreciates
(Pound
Depreciates)
$1
D1
0
Q1
Q
Quantity of Pounds
LO3
38-9
•
•
LO3
Flexible Exchange Rates
Determinants of exchange rates
Factors that shift demand/supply
–Changes in tastes
–Relative income changes
–Relative price-level changes
• Purchasing-power-parity theory
–Relative interest rates
38-10
Flexible Exchange Rates
The Market for Foreign Currency
(Pounds)
P
Dollar Price of 1 Pound
(Dollar/Euro)
S1
c
$3
Exchange
Rate:
$3 = £1
a
x
$2
b D
2
Exchange
Rate:
$2 = £1
$1
D1
0
Q1
Q2
Q
Quantity of Pounds
LO3
38-11
International Trade and Foreign Exchange Markets
Peso/U.S. dollar
Problem Set #3:
(a) If interest rates in the U.S. increase compared to those in
Mexico, how will that affect Mexican investment in the
U.S.?
(b) How will your answer to part (a) affect the demand for
dollars in the foreign exchange market? Draw a diagram
below.
Quantity of U.S. dollars
International Trade and Foreign Exchange Markets
Problem Set #3:
(c) How will your answer to part (b) affect the supply of
pesos in the foreign exchange market? Draw a diagram
below? What will happen to the dollar price of pesos? Show
this on your diagram.
U.S. dollars
/Canadian Dollars
International Trade and Foreign Exchange Markets
Problem Set #4:
(a) Assume the real interest rate in Canada increases
relative to the real interest rate in the U.S. Draw a graph
of the value of the Canadian dollar in terms of the U.S.
dollar that demonstrates this change.
Quantity of Canadian dollars
International Trade and Foreign Exchange Markets
Problem Set #4:
(b) Given your answer to part (a), what will happen to the
level of Canadian exports? Explain.
- Canadian exports will decrease because the
appreciation of the Canadian dollar makes Canadian
products more expensive for American consumers.
International Trade and Foreign Exchange Markets
Problem Set #4:
(c) Will there be an inflow or an outflow of capital into
Canada as a result of the change in interest rates in part (a)?
Explain.
- There will be an inflow of capital into Canada
because the higher relative interest rate in Canada will
attract foreign investment.
International Trade and Foreign Exchange Markets
Problem Set #4:
(d) Allright, now let’s put it all together. Reconcile the
Canadian balance of payments as a result of these changes?
(How will it balance?)
- The current account will be in deficit due to
decreased exports, but the financial (ne’e capital) account
will be in surplus due to greater foreign investment in
Canada. This will balance Canada’s balance of payments.
International Trade and Foreign Exchange Markets
Problem Set #5:
Assume there is an increase in investment demand in the
U.S.
(a) What will happen to the real interest rate?
(b) What will happen to the capital stock?
(c) What will happen to the international value of the
dollar?
International Trade and Foreign Exchange Markets
Problem Set #5:
Assume there is an increase in investment demand in the
U.S.
(d) Choose a graph to demonstrate your answers to
parts (a) and (c) (one graph for each part: 2 graphs total)
(a)
(c)
International Trade and Foreign Exchange Markets
Problem Set #6:
If the inflation rate in Kerseyland is much higher than that of
its neighbors, what will be the effect on
(a) The demand for its products?
(b) The value of its currency?
International Trade and Foreign Exchange Markets
Problem Set #7:
If the dollar appreciates compared to the rest of the world’s
currencies, what will be the effect on
(a) The volume of U.S. exports? Explain.
U.S. exports will decrease because the
appreciation of the dollar makes U.S. products more
expensive to foreigners.
(b) The volume of U.S. imports? Explain.
U.S. imports will increase because the dollar will
have more purchasing power in foreign countries due to the
increase in its value compared to foreign currencies.
International Trade and Foreign Exchange Markets
Problem Set #8:
Assume a French company buys computers from a U.S. firm.
Draw side by side graphs of the dollar and the Euro on the
Foreign Exchange market. Demonstrate the effect of this
transactions on both currencies.
FRQ #1
1. Japan, the European Union, Canada, and Mexico have flexible exchange rates.
(a) Suppose the real interest rate in Canada increases relative to that in Mexico.
(i) Using a correctly labeled graph of the foreign exchange market for
the Canadian dollar, show the effect of the change in real interest rate in Canada on the
international value of the Canadian dollar (expressed as Mexican pesos per Canadian
dollar).
FRQ #1
1. Japan, the European Union, Canada, and Mexico have
flexible exchange rates.
(ii) How will the change in the international value of
the Canadian dollar that you identified in part (a)(i) affect
Canadian exports to Mexico? Explain.
Canadian exports to Mexico will decrease because the
appreciation of the Canadian dollar makes Canadian
products more expensive for Mexican consumers.
FRQ #1
1. Japan, the European Union, Canada, and Mexico have flexible
exchange rates.
(b) Suppose Japan attracts an increased amount of
investment from the European Union.
(i) Using a correctly labeled graph of the loanable
funds market in Japan, show the effect of the increase in foreign
investment on the real interest rate in Japan.
FRQ #1
1. Japan, the European Union, Canada, and Mexico have flexible
exchange rates.
(b) Suppose Japan attracts an increased amount of
investment from the European Union.
(ii) How will the real interest rate change in Japan that
you identified in part (b)(i) affect the employment level in Japan in
the short run? Explain.
Lower real interest rates in Japan will lead to
increased investment* spending, which will increase
aggregate demand and output, leading to an increase in
the employment level.
*Note on AP scoring guidelines, I’m seeing the term
“interest-sensitive spending” a lot. I think you would get
credit for “investment spending,” but if you can remember,
use “interest-sensitive.” It includes consumer spending
financed by loans.
FRQ #2
1. Assume that yesterday the exchange rate between the euro and
the Singaporean dollar was 1 euro = 0.58 Singaporean dollars.
Assume that today the euro is trading at 1 euro = 0.60 Singaporean
dollars.
(a) How will the change in the exchange rate affect each of
the following in Singapore in the short run?
(i) Aggregate demand. Explain.
Aggregate demand will increase because the
depreciation of the Singaporean dollar makes Singapore’s
exports less expensive in Europe. Therefore, net exports
will increase in Singapore, increasing aggregate demand.
FRQ #2
1. Assume that yesterday the exchange rate between the euro and
the Singaporean dollar was 1 euro = 0.58 Singaporean dollars.
Assume that today the euro is trading at 1 euro = 0.60 Singaporean
dollars.
(a) How will the change in the exchange rate affect each of
the following in Singapore in the short run?
(ii) The level of employment. Explain.
Employment in Singapore will increase
because the increased aggregate demand will lead to
greater output, requiring greater employment.
FRQ #2
(b) Suppose that Singapore wants to return the exchange
rate to 1 euro = 0.58 Singaporean dollars.
(i) Should the Singaporean central bank buy or sell
euros in the foreign exchange market?
This Singaporean central bank should sell euros.
(This will increase the supply of euros on the foreign
exchange market, lowering the price of euros in terms of
Singaporean dollars.) (Or it will increase the demand for
Singaporean dollars.)
FRQ #2
1. Assume that yesterday the exchange rate between the euro and
the Singaporean dollar was 1 euro = 0.58 Singaporean dollars.
Assume that today the euro is trading at 1 euro = 0.60 Singaporean
dollars.
(b) Suppose that Singapore wants to return the exchange
rate to 1 euro = 0.58 Singaporean dollars.
(ii) Instead of buying or selling euros, what domestic openmarket operation can the Singaporean central bank use to achieve
the same result? Explain.
The Singaporean central bank could sell government
securities (bonds). This will raise interest rates in Singapore,
attracting foreign investment to Singapore and raising demand for
Singaporean dollars.