Chapter 6 -- International Finance and the Economy

1. Chapter 6 -- International Finance and the Economy • Measures of international finance. • Exchange rates, how they’re determined, and effects upon economy. • Closer look at theory of Net Exports, and the role of exchange rates within them.

2. Measures of International Finance • Record of transactions between American residents and residents of other countries over a flow interval. • Current Account • Capital Account • Balance of Payments

3. The Current Account • Current Account = {Exports + Foreign Transfers to US + Income earned from American holdings of investments abroad} -- {Imports + US Transfers to Foreigners + Income earned from foreign investments in US}

4. The Current Account: Interpretation • Items in the first set of { } -- current account inflows, ways that dollars enter into the US from international transactions in the current account. • Items in the second set of { } -- current account outflows, ways that dollars leave the US from international transactions in the current account.

5. The Current Account: Characteristics • Comprehensive measure of the Balance of Trade (NX is a close approximation).

6. The Capital Account • Capital Account = {Net Foreign Purchases of US Assets by foreign residents} - {Net US Purchases of Foreign Assets by US residents} • Capital Account = {Capital Account Inflows} - {Capital Account Outflows} • Can be interpreted as “net private borrowing” from the foreign sector.

7. The Balance of Payments (BOP) • Balance of Payments outcome = Current Account + Capital Account • Represents “what’s left over” after all international transactions between residents of the US (other than government) and residents of other countries (other than government) during a flow period. • Positive sign: Surplus, Negative Sign: Deficit • Balance of Payments deficits – financed by government borrowing from foreign sector.

8. The Recent US Record -- International Transactions • Current Account < 0 • Capital Account > 0, but less than |Current Account| • Balance of Payments < 0 • Negative Balance of Payments – financed by US borrowing from foreign sector.

9. Balance of Payments and Government Borrowing • Resulting equation: BOP + (Net Government Borrowing from Foreign Sector) = 0  (Current Account + Capital Account) + (Net Government Borrowing from Foreign Sector) = 0  (Current Account) + (Total Net Borrowing from Foreign Sector) = 0

10. The Balance of Payments and the “Magic Equation” • “Magic Equation”: S + (T – G) + (-NX) = I. • Balance of Payments equation:  Current Account + (Total Net Borrowing from Foreign Sector) = 0. • Also recall that NX  (Current Account). • Substitute the two expressions into Macro Identity for (-NX)  S + (T – G) + (Total Net Borrowing from Foreign Sector) = I.

11. Exchange Rates • (Nominal) Exchange Rate (e’) -- the amount of foreign currency needed to be exchanged for one (US) dollar. • Also known as the “value of the dollar”. • Conversion Ratio, in units of (foreign currency)/(US dollar)

12. Types of Exchange Rates • Bilateral Exchange Rates -- exchange rates between the US and an individual country. • Multilateral (Trade Weighted) Exchange Rate -- weighted average of bilateral exchange rates expressed as an index (macro measure of exchange rate).

13. Exchange Rate Changes e’  price of American goods and services to foreigners  price of foreign goods and services to Americans e’  price of American goods and services to foreigners  price of foreign goods and services to Americans

14. The Real Exchange Rate (e) e = (P)(e’) (Pf) P = US Price Level Pf = Foreign Price Level Key cause of net exports.

15. The Real Exchange Rate: An Interpretation e = (P)(e’) (Pf) Units of e: = ($/Quantity)(Foreign Currency/$) (Foreign Currency/Quantity) = (Foreign Currency/Quantity) (Foreign Currency/Quantity)

16. The Real Exchange Rate and Price Comparison e = (P)(e’) (Pf) • It consists of the ratio of the price level of American goods and services -- expressed in units of foreign currency -- to the price level of (corresponding) foreign goods and services.

17. The Real Exchange Rate and Net Exports • e (P, Pf, or e’)  substitution away from the relatively more expensive US goods and services  (US) Exports, (US) Imports  NX • e (P, Pf , or e’)  substitution into the relatively cheaper US goods and services  Exports, Imports  NX

18. Exchange Rate Regimes • Fixed (Pegged) Exchange Rates -- e’ fixed, unless changed by economic policy. • Floating Exchange Rates -- e’ determined by natural forces in the foreign exchange market. • Managed Float -- floating e’ with occasional Treasury/Federal Reserve intervention.

19. The Foreign Exchange Market -- Determination of e’ • The Foreign Exchange Market -- the demand and supply for dollars for use in international transactions.

20. Concepts to Understand Foreign Exchange Behavior • Items (goods, services, financial assets) are priced in a country’s home currency. • If one wishes to buy from another country, he/she must convert from their own currency to the currency of the country selling the item.

21. More Concepts: Foreign Exchange • The nominal exchange rate (e’) specifies the ratio of conversion. • One exchange rate (e’) is the conversion ratio for all foreign transactions (goods, services, financial assets) – Law of One Exchange Rate.

22. The Demand for Dollars • The Demand for Dollars -- foreigners demand for US dollars, to buy American goods, services, or financial assets. • Inversely related to the nominal exchange rate, with other causes (shift variables) as well.

23. The Supply of Dollars • The Supply of Dollars -- Americans supplying dollars to the foreign exchange market, in order to buy foreign goods, services, or financial assets. • Positively related to the nominal exchange rate, with other causes (shift variables) as well.

24. Foreign Exchange Market Equilibrium • Equilibrium exchange rate (foreign currency)/(US$) -- “price of dollars.” • At equilibrium: Current Account + Capital Account = 0 • At equilibrium, the Balance of Payments = 0.

25. Example 1 -- Increase in US Interest Rates (i) • Increase in i leads to substitution away from foreign financial assets to US financial assets. • Foreigners substitute  Demand for Dollars Increases (curve shifts rightward). • Americans Substitute  Supply of Dollars (Abroad) Decreases (curve shifts leftward). • As a result, the equilibrium exchange rate (e’*) Increases.

26. Example 2 -- Increase in Foreign Interest Rates (if) • Increase in if leads to substitution away from US financial assets to foreign financial assets. • Foreigners substitute  Demand for Dollars Decreases (curve shifts leftward). • Americans Substitute  Supply of Dollars (Abroad) Increases (curve shifts rightward). • As a result, the equilibrium exchange rate (e’*) Decreases.

27. Speculation -- Expectations of Exchange Rate Changes • Example 3 -- consider the exchange rate in units of foreign currency (abbreviation -- fcu) per dollar. • e’ = (5 fcu)/($1), and you expect (correctly) that it will decrease in the future to (4 fcu)/($1). • Response -- sell dollars now, buy them back when “cheaper.”

28. Capital Gains in the Foreign Exchange Market • Continue example, start with $100. • Step #1 -- buy foreign currency at the current exchange rate. (100$)[(5 fcu)/($1)] = 500 fcu. • Step #2 -- convert back to dollars when e’ decreases in the future. (500 fcu)[($1)/(4 fcu)] = $125. • Capital gain of $25.

29. Floating Exchange Rates • Advantages -- At market equilibrium, Balance of Payments = 0, i.e.  current account + capital account = 0. -- Federal Reserve does not need to participate in foreign exchange market, it can use the money supply to focus solely on domestic policy.

30. Floating Exchange Rates (Continued) • Disadvantages -- Fluctuating exchange rate is disruptive to International Trade (exchange rate risk). -- Exchange rates can fluctuate a great deal, especially due to speculation (speculative bubbles).

31. Fixed Exchange Rates • Advantages -- exchange rate is constant, stability in International Trade (exchange rate risk = 0).

32. Fixed Exchange Rates (Continued) • Disadvantages -- Federal Reserve must intervene constantly in the foreign exchange market to keep BOP = 0  loses control of money supply. -- Or country faces distorted Balance of Payments position (negative or positive) -- Fed might be forced into contractionary monetary policy to raise i* and increase e’* to the fixed rate.

33. Exchange Rate Regimes -- Overall • Ideal system: floating exchange rates which do not exhibit much movement. • Actual system (US): Managed Float -- floating exchange rates with occasional Federal Reserve intervention.

34. Exchange Rates and the Macro Models • Review concepts: -- Real exchange rate (e), e = (P)(e’)/(Pf). -- Real exchange rate is inversely related to net exports, i.e. e  NX.

35. Causes of Net Exports -- Fixed and Floating e’ • Foreign Output or Income (Yf) • US Output or Income (Y) • Barriers to Trade

36. Causes of Net Exports, Continued • Real Exchange Rate (e) -- US Price Level (P), P  e  NX -- Foreign Price Level, Pf   e  NX -- Nominal Exchange Rate (e’) e’  e  NX

37. Further Decomposition -- Causes of Net Exports • Real Exchange Rate (e) ... -- Nominal Exchange Rate (e’) (a) US interest rate (i) i e’*  e  NX (b) Foreign interest rate (if) if e’*  e  NX (c) Expectations of Future e’

38. Exchange Rates and the IS-LM Model • Note -- causes (a), (b), and (c) apply only to floating exchange rates. • Fixed Exchange Rates and the IS-LM Model -- e’ inflexible, cause of autonomous Net Exports, shifts IS curve.

39. Floating Exchange Rates and the IS-LM Model • Since the nominal interest rate is a cause of the nominal exchange rate and Net Exports, this behavior affects the slope of the IS curve. • Under floating exchange rates: i*  C, I, NX. • Additional response to interest rate change  greater elasticity flatter IS curve.

40. Floating Exchange Rates and Policy Effectiveness • Flatter IS curve under floating exchange rates makes fiscal policy less effective and monetary policy more effective.

41. Recent Developments – Exchange Rates • 1971-73: US Transitions From System of Fixed Exchange Rates to Floating Exchange Rates Against Major Industrialized Economies. • 2006-: US pressuring China to convert from Fixed Exchange Rate Regime to purely Floating Exchange Rate (How Much Will Yuan/$ Exchange Rate Decrease as a Result?).

42. Recent Developments -- International Trade • Movement toward reducing or removing trade barriers -- General Agreement on Tariffs and Trade (GATT) -- Replaced by World Trade Organization (WTO)

43. Free Trade Agreements Involving the US -- North American Free Trade Agreement (NAFTA), 1994. -- Central American Free Trade Agreement (CAFTA), 2005. -- Free Trade Agreement of the Americas (FTAA), Proposed.

44. More Developments • Creation of the European Union -- economic bonding of major European countries. -- removing barriers to trade among member nations -- common currency (Euro) -- one central bank for the community

45. Challenges to the European Union • Uniform currency equivalent to fixed exchange rate regime among member nations. • To avoid large scale foreign borrowing associated with fixed exchange rates and BOP < 0, need for coordinated economic policies among members. • Will nations with large budget deficits and very sluggish economies (e.g. Greece) accede to Germany’s fiscal-discipline based economy?