Chapter 34

1. Chapter 34 Exchange Rates and the Balance of Payments

2. The price of one currency in terms of another is set by the interaction of supply and demand in international financial markets. Among the participants in these markets are governments seeking to change or maintain exchange rates. Introduction

3. Learning Objectives • Distinguish between the balance of trade and the balance of payments • Identify the key accounts within the balance of payments • Outline how exchange rates are determined in the markets for foreign exchange

4. Learning Objectives • Discuss factors that can induce changes in equilibrium exchange rates • Understand how policymakers can go about attempting to fix exchange rates • Explain alternative approaches to limiting exchange rate variability

5. Chapter Outline • The Balance of Payments and International Capital Movements • Determining Foreign Exchange Rates • The Gold Standard and the International Monetary Fund • Fixed Exchange Rates

6. Did You Know That... • Exchange rates between currencies are a factor in determining the location of vehicle production? • The recent decline in the value of the dollar against the yen and the euro led foreign automakers to locate more vehicle assembly in the U.S.?

7. The Balance of Payments and International Capital Movements • Balance of Trade • The value of goods and services bought and sold in the world market • The difference between exports and imports of goods • Balance of Payments • A summary record of a country’s economic transactions with foreign residents and governments over a year

8. Surplus (+) and Deficit (-) Items on the International Accounts Surplus Items (+) Deficit Items (-) Exports of merchandise Imports of merchandise Private and government gifts from Private and governmental gifts to foreigners foreigners Foreign use of domestically owned Use of foreign-owned transportation transportation Foreign tourists’ expenditures in this country Tourism expenditures abroad Foreign military spending in this country Military spending abroad Interest and dividend receipts from foreigners Interest and dividends paid to foreigners Sales of domestic assets to foreigners Purchases of foreign assets Funds deposited in this country by foreigners Funds placed in foreign depository institutions Sales of gold to foreigners Purchases of gold from foreigners Sales of domestic currency to foreigners Purchases of foreign currency Table 34-1

9. The Balance of Payments and International Capital Movements • Accounting Identities • Statements that certain numerical measurements are equivalent by accepted definition

10. The Balance of Payments and International Capital Movements • When family expenditures exceed income, the family must do one of the following: • Reduce its money holdings, or sell stocks, bonds, or other assets • Borrow • Receive gifts from friends or relatives • Receive a public transfer from a government • Cannot continue indefinitely

11. The Balance of Payments and International Capital Movements • Accounting identities • Net lending by households must equal net borrowing by businesses and governments • Disequilibrium • When a situation cannot continue indefinitely

12. The Balance of Payments and International Capital Movements • Households, businesses, and governments must reach equilibrium. • When nations trade or interact, certain identities or constraints must hold.

13. The Balance of Payments and International Capital Movements • Three categories of balance of payments transactions • Current account transactions • Capital account transactions • Official reserve account transactions

14. The Balance of Payments and International Capital Movements • Current account transactions • Merchandise trade transactions • Importing and exporting of merchandise • Balance = merchandise exports - merchandise imports

15. The Balance of Payments and International Capital Movements • Current account transactions • Service exports and imports • Invisible or intangible items • Shipping • Insurance • Tourism • Banking • Income from investments

16. The Balance of Payments and International Capital Movements • Current account transactions • Unilateral transfers • Gifts by citizens • Gifts by governments

17. Example: Multinational Firms in Trade Statistics • When economic activities are conducted by multinational firms, there are different trade statistics that will be calculated depending on whether the activities are measured according to the ownership of resources or according to the location of productive activities.

18. Example: Multinational Firms in Trade Statistics • When the U.S. Commerce Department reports trade statistics on an ownership basis, exports and imports are adjusted to reflect purchases and sales involving foreign affiliates of U.S. firms.

19. The Balance of Payments and International Capital Movements • Balancing the current account • Net exports plus unilateral transfers plus net investment income exceeds zero • Current account surplus • Net exports plus unilateral transfers plus net investment income is negative • Current account deficit

20. The Balance of Payments and International Capital Movements • A current account surplus means the import of money or money equivalent which means a capital account deficit • A current account deficit must be paid by the export of money or money equivalent which means a capital account surplus

21. The Balance of Payments and International Capital Movements • Capital account transactions • Deals with the buying and selling of real and financial assets

22. Capital Account  Current Account  0 The Balance of Payments and International Capital Movements • The current account and capital account must sum to zero, in the absence of interventions by finance ministries or central banks.

23. The Balance of Payments and International Capital Movements • Official reserve account transactions • Foreign currencies • Gold • Special Drawing Rights (SDRs) • Reserve assets created by the International Monetary Fund that countries can use to settle international payments

24. The Balance of Payments and International Capital Movements • Official reserve account transactions • The reserve position in the International Monetary Fund • Financial assets held by an official agency such as the U.S. Treasury Department

25. The Balance of Payments and International Capital Movements • What affects the balance of payments? • Relative rate of inflation • Political stability

26. The Balance of Payments and International Capital Movements • What affects the balance of payments? • Inflation among trading partners • Political stability

27. Determining ForeignExchange Rates • Foreign Exchange Market • The market for buying and selling foreign currencies • Exchange Rates • The price of one currency in terms of another

28. Determining ForeignExchange Rates • Demand for and supply of foreign currency • U.S. transactions involving imports constitute a supply of dollars and demand for some foreign currency • The opposite is true for export transactions

29. Determining ForeignExchange Rates • The equilibrium foreign exchange rate • Appreciation • An increase in the value of a currency in terms of other currencies • Depreciation • A decrease in the value of a currency in terms of other currencies

30. 1,500 1,250 1,000 750 D 100 300 500 700 Deriving the Demandfor Japanese Yen Panel (b) U.S. Demand Curve for Japanese Laptop Computers Price per Unit ($) 0 Quantity of Japanese Laptops per Week Figure 34-2, Panels (a) and (b)

31. 1,500 1,250 1,000 750 D 100 300 500 700 Deriving the Demandfor Japanese Yen Panel (b) U.S. Demand Curve for Japanese Laptop Computers Price per Unit ($) 0 Quantity of Japanese Laptops per Week Figure 34-2, Panels (c) and (b)

32. .0150 .0125 .0100 .0075 D1 10 30 50 70 Deriving the Demandfor Japanese Yen Panel (e) U.S. Derived Demand for Yen Price per Franc ($) 0 Quantity of Yen Demanded per Week (millions) Figure 34-2, Panels (d) and (e)

33. Determining ForeignExchange Rates • Supply of Japanese Yen • Price of U.S. microprocessor = $200 • Exchange rate = $0.01 for 1 yen • 200,000 yen ($200@$0.01/yen) = 1 microprocessor • Exchange rate = $0.0125 • 16,000 Yen ($200@ $0.0125/Yen) = 1 microprocessor

34. S 0.0125 0.0100 0.0075 40 50 60 Determining Foreign Exchange Rates Price per Yen ($) 0 Quantity of Yen Supplied per Week (millions) Figure 34-3

35. S 0.0125 E 0.0100 D 2 3 Total Demand for and Supply of Japanese Yen Price per Yen($) 0 Trillions of Yen per Year Figure 34-4

36. S E 2 0.0120 E 1 0.0100 D 2 D 1 3 4 A Shift in the Demand Schedule Price per Yen ($) 0 Trillions of Yen per Year Figure 34-5

37. S E 0.0100 S 1 E 1 0.0050 D 3 5 A Shift in the Supply of Japanese Yen Price per Yen ($) 0 Trillions of Yen per Year Figure 34-6

38. International Example: South Africa’s Currency Appreciation • Gold and platinum are key South African exports. • The increased demand for these commodities has also increased the demand for South African rand. • As interest rates in South Africa became relatively higher, the demand for South African financial assets also increased.

39. International Example: South Africa’s Currency Appreciation • The result of these changes has been an appreciation of the rand. • The dollar price of the rand has doubled since the end of 2001.

40. Determining ForeignExchange Rates • Market determinants of exchange rates • Changes in real interest rates • Changes in productivity • Changes in product preferences • Perceptions of economic stability

41. The Gold Standard and the International Monetary Fund • Gold Standard • An international monetary system in which nations fix their exchange rates in terms of gold • All currencies are fixed in terms of all others, and any balance of payments deficits or surpluses can be made up by shipments of gold

42. The Gold Standard and the International Monetary Fund • Gold standard • A balance of payments deficit • More gold flowed out than flowed in • Equivalent to an restrictive monetary policy • A balance of payments surplus • More gold flowed in than out • Equivalent to an expansionary monetary policy

43. The Gold Standard and the International Monetary Fund • Problems with the gold standard • A nation gives up control of its monetary policy • New gold discoveries often caused inflation

44. The Gold Standard and the International Monetary Fund • Bretton Woods and the International Monetary Fund • 1944—representatives of capitalist countries met in Bretton Woods, New Hampshire • Created a new international payment system to replace the gold standard • Members could change the par value once by 10 percent and after that par value changes needed IMF approval

45. The Gold Standard and the International Monetary Fund • End of the old IMF • On August 15, 1971, President Richard Nixon suspended the convertibility of the dollar into gold. • On December 18, 1971, the United States devalued the dollar relative to the currencies of 14 major industrial nations.

46. Current Foreign Exchange Rate Arrangements Figure 34-7

47. Fixed versus Floating Exchange Rates • To maintain a fixed exchange rate, the central bank of a country can buy and sell currencies. • It must use its own foreign exchange reserves to engage in these financial market transactions.

48. A Fixed Exchange Rate • The supply of ringgit shifts to the right as Thai residents demand more U.S. goods • The value of the ringgit will fall The Bank of Malaysia buys ringgit with dollars shifting the demand for ringgit to the right Figure 34-8

49. International Example:Central Banks’ Currencies of Choice • A central bank allocates foreign exchange reserves based on its perception of which currencies will be needed most frequently to alter the demand for its own currency. • The U.S. dollar is the currency most commonly held in foreign exchange reserves; but the euro, the Japanese yen, and the British pound also comprise a measurable portion of these accounts.

50. Fixed Exchange Rates • Pros and cons of fixed exchange rates • Pros • Limiting foreign exchange risk • The possibility that changes in the value of a nation’s currency will result in variations in market value of assets