C H A P T E R C H E C K L I S T

1 2 C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • Describe a countries balance of payments accounts and explain what determines the amount of international borrowing and lending. Explain how the exchange rate is determined and why it fluctuates.

20.1 FINANCING INTERNATIONAL TRADE • Balance of Payment Accounts • Balance of payments • The accounts in which a nation records all transactions that cross borders, including its international trading, borrowing, and lending. Based on payments: if the payment comes IN, recorded as positive; if the payment goes OUT, recorded as negative. • Currentaccount • Record of international receipts and payments that do not involve exchange of assets or liabilities —current account balance equals exports minus imports, plus net factor income [interest etc] and transfers received from abroad.

20.1 FINANCING INTERNATIONAL TRADE • Capital account • Record of all transactions involving change of ownership of assets or liabilities; includes foreign lending and borrowing, and foreign investment in the United States minus U.S. investment abroad. • Official settlements account • Record of the change in U.S. official reserves. • U.S. official reserves • The government’s holdings of gold, foreign currency, and Special Drawing Rights [IMF ‘fiat money’].

20.1 FINANCING INTERNATIONAL TRADE

20.1 FINANCING INTERNATIONAL TRADE • Silly Individual Analogy • An individual’s current account records the income from supplying the services of factors of production and the expenditures on goods and services. • An example: In 2000, Joanne • Worked and earned labor income of $25,000. • Had investments that paid interest and dividends of $1,000. • Her labor income of $25,000 is analogous to a country’s current exports. • Her $1,000 of interest and dividends is analogous to acountry’s factor income from abroad.

20.1 FINANCING INTERNATIONAL TRADE • Joanne: • Spent $18,000 buying goods and services to consume. • Herconsumption expenditure is analogous to a country’s imports. Hercurrent account balance was $26,000 – $18,000, a surplus of $8,000. • But she did something else, namely she • Bought a house, which cost her $60,000. • This was acquiring an asset, so it is analogous to investment abroad – an outlay [negative entry] in the capital account. • For a country, balance on current account plus balance on capital account equals change in official reserves. Is this true for Joanne?

20.1 FINANCING INTERNATIONAL TRADE • To pay for the $60,000 house, Joanne borrowed $50,000 from the bank, used the $8,000 surplus on her current account, and used $2,000 that she had in her bank account. • Joanne’s borrowing is analogous to a country’s borrowing from the rest of the world. So on her capital account, she has minus $60,000 [paying for the house] and plus $50,000 [what she borrowed; the payment came to her], for a deficit of $10,000. • The change in her bank account is analogous to the change in the country’s official reserves. So, current account balance + capital account balance = +$8,000 -$10,000 = -$2,000 = change in official reserves.

20.1 FINANCING INTERNATIONAL TRADE • Borrowers and Lenders, Debtors and Creditors • Net borrower • A country that is borrowing more from the rest of the world than it is lending to the rest of the world.Flow concept. • Net lender • A country that is lending more to the rest of the world than it is borrowing from the rest of the world.Flow concept. • Note ‘lending’ and ‘borrowing’ here include ‘direct investment’ – acquiring assets like factories or shares in companies. .

20.1 FINANCING INTERNATIONAL TRADE • Debtor nation • A country that during its entire history has borrowed more from the rest of the world than it has lent to it. • A debtor nation has a stock of outstanding debts to the rest of the world that exceeds the stock of its own claims on the rest of the world.Stock concept. • Creditor nation • A country that has invested more in the rest of the world than other countries have invested in it.Stock concept.

20.1 FINANCING INTERNATIONAL TRADE • Flows and Stocks • Borrowing and lending are flows. • Debts are stocks - amounts owed at a point in time. • The flow of borrowing and lending changes the stock of debt. • Since 1989, the total stock of U.S. borrowing from the rest of the world has exceeded U.S. lending to the rest of the world. Whether the U.S. is truly a debtor or creditor is hard to tell, because it is very hard to accurately value ‘direct investment’ – U.S. ownership of physical assets abroad, foreign ownership of physical assets here – because many such assets were acquired long ago.

20.2 THE EXCHANGE RATE • Foreign exchange market • The market in which the currency of one country is exchanged for the currency of another. • The foreign exchange market is made up of importers and exporters, banks, and specialist dealers who buy and sell currencies. Largely done electronically nowadays; dealers sit in front of computer screens. Major centers for the foreign exchange markets are New York, London, Frankfurt, Singapore and Hong Kong, Tokyo.

20.2 THE EXCHANGE RATE • Foreign exchange rate • The price at which one currency exchanges for another. • For example, in November 2002, one U.S. dollar bought 122 Japanese yen. The exchange rate was 122 yen per dollar. • This exchange rate can be expressed in terms of cents per yen. In November 2002, the exchange rate was a bit less than 0.8 cents per yen. • Exchange rates are prices that change frequently: • Friday, November 28, 2003 1 US Dollar = 109.160 Japanese Yen 1 Japanese Yen (JPY) = 0.009161 US Dollar (USD)

20.2 THE EXCHANGE RATE • JARGON: Currency depreciation • The fall in the value of one currency in terms of another currency. • For example, if the exchange rate falls from 108 yen per dollar to 105 yen per dollar, the U.S. dollar depreciates. The price of the dollar in yen has come down. • Currency appreciation • The rise in the value of one currency in terms of another currency. • For example, if the exchange rate rises from 108 yen per dollar to 110 yen per dollar, the U.S. dollar appreciates. The price of the dollar in yen has gone up.

20.2 THE EXCHANGE RATE • The value of the foreign exchange rate – the price of the dollar in terms of other currencies -- fluctuates. • Sometimes the U.S. dollar depreciates and sometimes it appreciates. Why? • The foreign exchange rate is a price and like all prices, demand and supply in the foreign exchange market determine its value. • But foreign exchange markets are somewhat unusual markets, with some special features. In foreign exchange markets, supply and demand are derived from the need to make payments in the other currency, which themselves derive from desires to buy goods, services, or assets [physical or financial] from the other country.

20.2 THE EXCHANGE RATE • Demand in the Foreign Exchange Market • The quantity of dollars demanded in the foreign exchange market is the amount that traders plan to buy during a given period at a given exchange rate. • The quantity of dollars demanded depends on: • The exchange rate • Macroeconomic conditions in the US and rest of the world • Interest rates in the United States and other countries • The expected future exchange rate

20.2 THE EXCHANGE RATE • Demand for Foreign Exchange • Other things remaining the same, the higher the exchange rate [price of a dollar], the smaller is the quantity of dollars demanded. • The exchange rate influences the quantity of dollars demanded for two main reasons: • Exports effect • Expected profit effect

20.2 THE EXCHANGE RATE • Exports Effect • The larger the value of U.S. exports, the larger is the quantity of dollars demanded on the foreign exchange market – foreigners need dollars to pay for US exports. • The lower the exchange rate, the cheaper are U.S.-made goods and services for people in the rest of the world, the more the United States exports, and the greater is the quantity of U.S. dollars demanded to pay for them.

20.2 THE EXCHANGE RATE • Expected Profit Effect • The larger the expected profit from holding dollars [or assets priced in dollars], the greater is the quantity of dollars demanded in the foreign exchange market. • But the expected profit [in the future] depends on the exchange rate [now]. • The lower the exchange rate, other things remaining the same, the larger is the expected profit from holding dollars and the greater is the quantity of dollars demanded.

Figure 20.1 shows the demand for dollars. 20.2 THE EXCHANGE RATE 1. If the exchange rate rises, the quantity of dollars demanded decreases along the demand curve for dollars. 2.If the exchange rate falls, the quantity of dollars demanded increases along the demand curve for dollars.

20.2 THE EXCHANGE RATE • Changes in the Demand for Dollars • Any influence, other than the exchange rate, that changes the quantity of U.S. dollars that people plan to buy in the foreign exchange market changes the demand for U.S. dollars and shifts the demand curve for dollars. • These influences include: • Interest rates in the United States and other countries • Relative macroeconomic conditions in the US and other countries • Expected future exchange rates

20.2 THE EXCHANGE RATE • Interest Rates in the United States and Other Countries • U.S. interest rate differential • The U.S. interest rate minus the foreign interest rate. • Other things remaining the same, the larger the U.S. interest rate differential, the greater is the demand for U.S. financial assets and the greater is the demand for dollars on the foreign exchange market. • Obviously, the U.S. interest rate differential can be either positive or negative.

20.2 THE EXCHANGE RATE • The Expected Future Exchange Rate • Other things remaining the same, the higher the expected future exchange rate, the greater is the demand for dollars. • The higher the expected future exchange rate, the larger is the expected profit from holding dollars, so the larger is the quantity of dollars that people plan to buy on the foreign exchange market.

Figure 20.2 shows changes in the demand for dollars. 20.2 THE EXCHANGE RATE 1. An increase in the demand for $’s 2. A decrease in the demand for $’s.

20.2 THE EXCHANGE RATE • Supply in the Foreign Exchange Market • The quantity of U.S dollars supplied in the foreign exchange marketis the amount that traders plan to sell during a given time period at a given exchange rate. • The quantity of U.S. dollars supplied depends on many factors, but the main ones include: • The exchange rate • Interest rates in the United States and other countries • Relative macroeconomic conditions in the US and the rest of the world • The expected future exchange rate Note the symmetry with the factors that influence the demand for $’s – an unusual aspect of this market.

20.2 THE EXCHANGE RATE • The Law of Supply of Foreign Exchange • Traders supply U.S. dollars in the foreign exchange market when they buy other currencies. • Other things remaining the same, the higher the exchange rate, the greater is the quantity of U.S. dollars supplied in the foreign exchange market. • The exchange rate influences the quantity of dollars supplied for two reasons: • Imports effect • Expected profit effect

20.2 THE EXCHANGE RATE • Imports Effect • The larger the value of U.S. imports, the larger is the quantity of foreign currency demanded to pay for these imports. • When people buy foreign currency, they supply dollars. • Other things remaining the same, the higher the exchange rate, the cheaper are foreign-made goods and services to Americans. Soimports increase, and the more the United States imports, the greater is the quantity of U.S. dollars supplied on the foreign exchange market.

20.2 THE EXCHANGE RATE • Expected Profit Effect • The larger the expected profit from holding a foreign currency, the greater is the quantity of that currency demanded and so the greater is the quantity of dollars supplied to the foreign exchange market. • The expected profit [in the future] depends on the exchange rate [now]. • Other things remaining the same, the higher the exchange rate, the larger is the expected profit from selling dollars and the greater is the quantity of dollars supplied in the foreign exchange market.

Figure 20.3 shows the supply of dollars. 20.2 THE EXCHANGE RATE 1. If the exchange rate rises, the quantity of $’s supplied increases along the supply curve for $’s. 2. If the exchange rate falls, the quantity of $’s supplied decreases along the supply curve for $’s.

20.2 THE EXCHANGE RATE • Changes in the Supply of Dollars • Any influence (other than the current exchange rate) that changes the quantity of U.S. dollars that people plan to sell in the foreign exchange market changes the supply of U.S. dollars and shifts the supply curve for dollars. • These influences include: • Interest rates in the United States and other countries • Relative macroeconomic conditions in the U.S. and the rest of the world • Expected future exchange rate

20.2 THE EXCHANGE RATE • Interest Rates in the United States and Other Countries • The larger the U.S. interest rate differential, the smaller is the demand for foreign assets and so the smaller is the supply of U.S. dollars on the foreign exchange market. • Macroeconomic Conditions • Relative macro conditions affect demand for imports and exports, and assessments of future growth prospects and thus desire to invest or not. The better conditions are abroad relative to the U.S., the more the supply of dollars as the U.S. makes investments abroad, but the less the supply of dollars as the U.S. sells more exports. The net effect is ambiguous.

20.2 THE EXCHANGE RATE • The Expected Future Exchange Rate • Other things remaining the same, the higher the expected future exchange rate, the smaller is the expected profit from selling U.S. dollars today, so the smaller is the supply of dollars today.

20.2 THE EXCHANGE RATE 1. An increase in the supply of dollars. 2. A decrease in the supply of dollars.

20.2 THE EXCHANGE RATE • Market Equilibrium • Demand and supply in the foreign exchange market determines the exchange rate. • If the exchange rate is too low, there is a shortage of dollars. • If the exchange rate is too high, there is a surplus of dollars. • At the equilibrium exchange rate, there is neither a shortage nor a surplus.

1. If the exchange rate is 120 yen per dollar, there is a surplus of dollars and the exchange rate falls. 20.2 THE EXCHANGE RATE 2.If the exchange rate is 80 yen per dollar, there is a shortage of dollars and the exchange rate rises.

3.If the exchange rate is 100 yen per dollar, there is neither a shortage nor a surplus of $’s and the exchange rate remains constant.The market is in equilibrium. 20.2 THE EXCHANGE RATE

20.2 THE EXCHANGE RATE • Changes in the Exchange Rate • The predictions about the effects of changes in the demand for and supply of dollars are exactly the same as for any other market. • An increase in the demand for dollars with no change in supply raises the exchange rate. • A increase in the supply of dollars with no change in demand lowers the exchange rate.

20.2 THE EXCHANGE RATE • Why the Exchange Rate Is Volatile • Sometimes the dollar appreciates and sometimes it depreciates, but the quantity of dollars traded each day barely changes. • Why? • The main reasons are: • Demand and supply are not independent in the foreign exchange market. • Expectations of future exchange rate changes play a very powerful role, because the profit or loss from a small exchange rate change can dominate other influences.

20.2 THE EXCHANGE RATE • A Depreciating Dollar: 1994–1995 • Between 1994 and the summer of 1995, the dollar depreciated against the yen. The exchange rate fell from 100 yen to a low of 84 yen per dollar. • An Appreciating Dollar: 1995 –1998 • Between 1995 and 1998, the dollar appreciated against the yen. The exchange rate rose from 84 yen to 130 yen per dollar. • We can draw graphs to illustrate this, emphasizing changes in expectations:

The dollar depreciated between 1994 and the summer of 1995. 20.2 THE EXCHANGE RATE 1.Traders expected the $ to depreciate— the demand for U.S. $’s decreased and the supply of U.S. $’s increased. 2. The dollar depreciated.

The $ appreciated between 1995 and 1998. 20.2 THE EXCHANGE RATE 1.Traders expected the $ to appreciate — the demand for U.S. $’s increased and the supply of U.S. $’s decreased. 2. The dollar appreciated.

20.2 THE EXCHANGE RATE • Exchange Rate Expectations • Why do exchange rate expectations change? • There are many forces, but two involve basic economics and are easy to understand: • Purchasing power parity • Interest rate parity • JARGON: Purchasing Power Parity • Equal value of money — a situation in which the same amount of money buys the same amount of goods and services in different countries using different currencies.

20.2 THE EXCHANGE RATE • Suppose that a Big Mac costs $4 (Canadian) in Toronto and $3 (U.S.) in New York. • If the exchange rate is $1.33 Canadian per U.S. dollar, then the two monies have the same value—you can buy a Big Mac in Toronto or New York for either $4 (Canadian) or $3 (U.S.). • But if a Big Mac in New York rises to $4 and the exchange rate remains at $1.33 Canadian per U.S. dollar, then the same amount of money buys more in Canada than in the United States. This would run counter to Purchasing Power Parity. • But, note that if you live in New York you are not likely to buy your Big Macs in Toronto; Purchasing Power Parity should only be expected for tradable goods and services, which is why it does not rule fully and only indicates one influence on exchange rates.

20.2 THE EXCHANGE RATE • The value of money is determined by the price level. If prices in the United States rise faster than prices in other countries, people will tend to expect the foreign exchange value of the U.S. dollar to fall to preserve rough purchasing power parity. Demand for U.S. dollars will decrease and supply will increase. The U.S. dollar exchange rate will fall. The U.S. dollar depreciates. So, the currency of a country with a more rapid inflation rate will tend to depreciate relative to the currencies of countries with slower inflation rates.

20.2 THE EXCHANGE RATE • If prices in the United States rise more slowly than prices in other countries, people will tend to expect the foreign exchange value of the U.S. dollar to rise, to preserve rough purchasing power parity. • Demand for U.S. dollars will increase and supply will decrease. • The U.S. dollar exchange rate will rise. • The U.S. dollar appreciates. So, the currency of a country with a slower inflation rate will tend to appreciate relative to the currencies of countries with more rapid inflation rates.

20.2 THE EXCHANGE RATE • Interest Rate Parity • JARGON: Interest Rate Parity • Equal interest rates—a situation in which the interest rate in one currency equals the interest rate in another currency when expected exchange rate changes and risk differences are taken into account. • We expect the US interest rate to be equal to the foreign interest rate plus/minus the expected percentage change in the foreign exchange rate over the relevant time period.

20.2 THE EXCHANGE RATE • Suppose a Canadian dollar deposit in a Toronto bank earns 5 percent a year and a U.S. dollar deposit in New York earns 3% percent a year. • If people expect the Canadian dollar to depreciate by 2 percent in a year, then the expected fall in the value of the Canadian dollar must be subtracted to calculate the net return on the Canadian dollar deposit. • The net return on the Canadian dollar deposit is 3 percent (5 percent minus 2 percent) a year. Interest rate parity would hold. • Of course, we can’t observe expectations; but interest rate differentials are a guide to what they are.

20.2 THE EXCHANGE RATE • Adjusted for risk, we should expect interest rate parity to always hold. • Traders in the foreign exchange market can and do move large amounts of funds into the currencies that they expect to earn the highest return quickly and cheaply. • This action of buying and selling currencies should bring about interest rate parity ex ante, i.e. in terms of expectations looking forward. Ex post, looking back after the fact, interest rate parity need not always hold, because there can be ‘surprise’ changes in exchange rates because of other things that change people’s expectations [like wars, elections, changes in macroeconomic conditions].

C H A P T E R C H E C K L I S T