Mr. Maurer
AP Economics (Macro)
Name: __________________________
International Trade and Foreign Exchange Markets
Problem Set #2
1. Evaluate each of the transactions on the U.S. balance of payments and complete the following table.
A. Ford Motor Company buys $50 million worth of production
machinery from a German company.
B. A U.S. entrepreneur invests $100 million to build a new
soccer stadium in Brazil.
C. A Chinese company sells 1 million U.S. flags to Wall-Mart.
D. Toyota pays $1 million to a U.S. shipping company to ship
Priuses to the U.S.
E. Each month, Thanas sends $100 to his grandparents back in
Greece.
F. Bank of America pays $10 million in interest to Russian
depositors.
G. Ryan O’Flannery, Irish business man, buys a condominium
building in Florida.
H. A South African track star buys $10,000 in U.S. Treasury
bonds.
I. Canadian tourists spend $20 million in the U.S. while
American tourists spend $20 million in Canada.
J. Best Buy buys $1 billion worth of TVs from Korean
company, Samsung.
Credit or
Debit (+ or -)
Current Account or
Financial Account
Debit
Current
Debit
Financial
Debit
Current
Credit
Current
Debit
Current
Debit
Current
Credit
Financial
Credit
Financial
Equal
Current
Debit
Current
The Current Account, The Financial Account, and the Loanable Funds Market
Remember that the current account balance and the financial account balance must sum to zero (actually, if they
don’t, a country will have to use its official reserves of foreign currency to make up the difference, which is
considered to be a transaction in the financial account). Consider the example of the United States, which
imports more than it exports. Those imports must be paid for with foreign currency, and if not enough foreign
currency is earned by selling exports, it will have to be brought into the U.S. through foreign financial
investment. If not, the U.S. will have to draw down its official reserves of foreign currency to make up the
difference.
Any deficit in the current account will have to be matched by a surplus in the financial account and vice versa.
2. Assume there are only two countries in the world, Country A and Country B. Assume that Country A is
running a current account deficit.
a. What must be true of Country A’s financial account? Explain.
It must be in surplus because the current account and the financial account must sum to zero.
b. What must be true of Country B’s current account?
It must be in surplus.
c. What must be true of Country B’s financial account?
It must be in deficit
d. Draw a graph of the loanable funds market for Country B below. On your graph, show how an
increase in Country A’s current account deficit affects the supply of loanable funds and the real interest rate in
Country B. Before you draw your graph, answer these questions to clarify the situation:
i. If Country A’s current account deficit increases, what will happen to its financial account?
The surplus in its financial account will increase.
ii. In that case, what will happen to Country B’s financial account (remember, there are only
two countries in the world)?
The deficit in Country B’s financial account will increase
With these answers, you should be able to draw a graph of the loanable funds market in Country
B that represents these changes. Do this below.
The graph at left shows the supply of loanable funds
in Country B decreasing as financial capital flows
from Country B to Country A. Country B’s financial
account deficit literally means that they are sending
more financial capital to other countries than they are
receiving from other countries. This financial capital
is what makes up the supply of loanable funds.
To sum up this point, foreign investment flowing into a country increases the supply of loanable funds into that
country. Foreign investment flowing out of a country decreases the supply of loanable funds in that country.
Look back at your loanable funds graph for Country B on the previous page. You should have a graph that
shows the supply of loanable funds shifting to the left and the real interest rate increasing. This is because, if
Country A’s current account deficit increases, its financial account surplus must increase (remember the two
must balance). This means more foreign investment is flowing into Country A, which means it is flowing out of
Country B. Therefore, the supply of loanable funds in Country B will decrease.
Appreciation, Depreciation, and the Foreign Exchange Market
Now let’s look at the concepts of appreciation and depreciation. If the value of a currency goes up in terms of
another country’s currency, that currency is said to have appreciated. (We also say the currency has appreciated
if its value goes up in general, against most other currencies in the world). If the value of the currency goes
down, it is said to have depreciated. The values of these currencies are established in the foreign exchange
market through the forces of supply and demand, just like any other market we have studied.
It’s really very simple. If foreign consumers want to buy U.S. goods, they will need dollars to do so, so they will
demand U.S. dollars in the foreign exchange market. This increased demand will increase the value of the dollar
in terms of the foreign currency involved. Let’s say in this case, the foreign country is France (because I’ve been
to France and I liked it), and the foreign currency is the euro. If French consumers want to buy $1 million worth
of American cars, they will demand 1 million U.S. dollars in the foreign currency market. This will increase
demand for U.S. dollars and cause the dollar to appreciate against the euro. Remember, there are thousands of
other transactions going on between France and the United States, all of them shifting demand and supply of
both the dollar and the euro, so we have to look at this example ceteris paribus, or by itself in isolation.
Anyway, French consumers need one million U.S. dollars for this particular purchase, so they demand one
million dollars in the foreign exchange market, increasing demand for U.S. dollars, causing the dollar to
appreciate against the euro.
Now, let’s stop a second and realize that we can say this another way. We could say that the French are
supplying euros in the foreign exchange market, increasing the supply of euros and causing the euro to
depreciate against the dollar. This is exactly what is happening. In fact, we can see from this, that there are
actually two foreign exchange markets at work here: the market for dollars and the market for euros. We can
show this with side by side graphs.
And notice that these two graphs are totally consistent. As the French demand more dollars, they supply more
Euros. The dollar appreciates against the euro and the euro depreciates against the dollar. Now, again, there are
thousands of other transactions happening between France and the U.S., so this single purchase is unlikely to
have any noticeable effect on the exchange rate, but ceteris paribus, this is the effect it would have, and it is one
of those thousands of transactions that together establish the exchange rate for the currencies of the world.
3. Now you draw a couple of FOREX (foreign exchange market) graphs. Assume that a U.S. importer purchases
one billion dollars’ worth of clothes made in China. Draw side by side graphs of the forex market for dollars and
the forex market for yuan (the Chinese currency) in the space below. Be sure to label them properly and show
the effect of this transaction on the value of both currencies.
The Determinants of Demand for Currencies
There are a number of factors that determine the demand for a country’s currency. Here are some of the most
important in terms of your success on the AP test. I’m going to use the U.S. and France for each, but they apply
equally to any other two countries.
- The relative price level in the country. If prices in the U.S. are generally lower than they are in
France, the French consumers will demand more U.S. goods. To buy these U.S. goods they will need U.S.
dollars. This will increase demand for U.S. dollars and cause the dollar to appreciate against the euro. At the
same time, prices will be higher in France than in the U.S. American consumers will demand less French goods,
reducing demand for the euro, causing the euro to depreciate against the dollar. Makes perfect sense: if the
dollar appreciates against the euro, the euro must decrease against the dollar. It’s just like the side by side graphs
on the previous page.
- Relative real interest rates. If real interest rates are higher in the U.S. than they are in France, French
investors will want to invest more money in the U.S. To do so, they will need dollars. This will increase demand
for U.S. dollars and you know the rest of the story.
- Relative income (or GDP, or output) changes. First of all, remember, national income, real GDP,
and output are all the same thing. What happens if U.S. income grows faster than national income in France.
Then Americans are going to buy more of everything, including French imports, while French consumers are
not going to increase their purchase of American imports. This will increase American demand for euros,
causing the euro to appreciate against the dollar and the dollar to depreciate against the euro. In general, if a
country’s economy is expanding more rapidly than most other countries’, its currency will depreciate as it
demands more foreign currency (or supplies more of its own currency) in the foreign exchange market.
- Changes in tastes. This is pretty straight forward. If Americans all of the sudden want French
products more, they’re going to buy more of them (ceteris paribus, of course). If Americans buy more French
products, they will demand more euros, pushing the value of the euro up against the dollar.
You can figure out all of these various scenarios with pretty simple supply and demand graphs. Sometimes you
can go straight to the FOREX graph, sometimes you’ll need to start with an AD/AS graph (maybe, to see what’s
happening to price level, or GDP, or whatever the question calls for.) The point is, once you figure out what’s
happening to the demand and supply of a currency, you can figure out whether it will appreciate or depreciate in
the foreign exchange market.
Time for some practice problems:
4. If the exchange rate between the U.S. dollar and the British pound changes from $2 per £1 to $3 per £1, and
the domestic price level in both countries stayed the same, we would say that the U.S. dollar has
appreciated/depreciated (circle one). What would happen to British exports in this case? Explain.
Depreciated. British exports would decrease because the depreciation of the U.S. dollar would make
British goods more expensive for U.S. consumers.
5. Would each of the following cause an appreciation or a depreciation of the U.S. dollar on the foreign
exchange market? Explain your answer.
- A decrease in interest rates in the U.S. Depreciation. Lower interest rates would make investment
in the U.S. less attractive to foreign investors, lowering demand for the U.S. dollar.
- A decrease in the U.S. consumer price index. Appreciation. Lower prices in the U.S. would make
U.S. goods more affordable (and more attractive) to foreign consumers, increasing foreign purchases of
U.S. goods and increasing demand for the dollar.
6. If the real interest rate in the U.S. increases relative to the rest of the world, will financial capital flow into or
out of the United States? What will happen to the value of the dollar? Explain.
Financial capital will flow into the U.S. because higher interest rates will make investment in the U.S.
more attractive to foreign investors. This will increase demand for the dollar, causing the value of the
dollar to appreciate.
7. Will each of the following cause the dollar to appreciate or depreciate against the euro?
- Household income rises in the United States. Depreciate. (U.S. consumers will have more money to
spend. They will spend some of that on foreign products, supplying more U.S. dollars in the forex
market.)
- Interest rates in the U.S. increase. Appreciate. (Investment will be more attractive in the U.S.,
attracting foreign investment and increasing the demand for dollars.)
- Household income in Europe rises. Appreciate. (European consumers will have more money to
spend, they will spend some of that on U.S. products, increasing demand for dollars (or increasing supply
of euros, whichever way you want to look at it.)
- The interest rate in Europe decreases. Appreciate. Lower interest rates will make investment in
Europe less attractive to Americans, so they will demand fewer euros (and supply fewer dollars) on the
forex market.
- The price level in the U.S. decreases. Appreciate. Lower prices in the U.S. will make U.S. products
more attractive to foreign consumers, who will demand more U.S. dollars for their increased purchases.
8. Assume that the U.S. price level rises faster than the German price level. In the space below, draw side-byside graphs of the dollar and the euro reflecting this change. Write a brief explanation for the changes you
diagram.
Lower prices in Germany will
make German products more
attractive to U.S. consumers,
which will increase the demand
for euros and the supply of
dollars on the foreign exchange
market.
9. Assume that real interest rates in the U.S. rise faster than those in Canada. In the space below, draw side-byside graphs of the U.S. dollar and the Canadian dollar reflecting this change. Write a brief explanation for the
changes you diagram.
Higher interest rates in the
U.S. will make investment in
the U.S. more attractive to
Canadians, increasing the
demand for U.S. dollars and
the supply of Canadian
dollars.
10. Assume that French tourists visit Japan in especially large numbers this year. In the space below, draw sideby-side graphs of the euro and the yen reflecting this change. Write a brief explanation for the changes you
diagram.
OK, this is the same as the two examples above. In this case the demand for the yen will increase because
French tourists are spending more in Japan than normal. This will also increase the supply of euros. It
should look just like the graphs above in #9, with yen on the left and euros on the right.
11. Assume that, due to an effective marketing campaign, Japanese video games become more popular with
U.S. children. In the space below, draw side-by-side graphs of the U.S. dollar and the yen reflecting this change.
Write a brief explanation for the changes you diagram.
Finally, this is also just like the problems above. The demand for yen will increase and the supply of
dollars will increase, increasing the value of the yen and depreciating the dollar. Again, just like the
graphs in #9, with yen on the left and U.S. dollars on the right.